What Are the Effects of High Cost of Capital?
The cost of capital is term that is used to describe both the cost of debt and the cost of equity that is associated with a financial endeavor. Essentially, this means that in order for the project to be profitable and worth the resources and risk that investors assume, that project must produce at least a certain minimum of return. With a high cost of capital, this can have an effect on not only how the investors go about securing funding for the project but also how much of a return must be generated in order to make the endeavor worth the effort.
Since the high cost of capital has to do with what is needed in the way of finances to support a project, the figure will also have some influence over how those resources are generated to cover the costs. Depending on how much capital is required, the effort may call for issuing some sort of bond issue that provides the money up front to fund the project, with the expectation that it will become self-supporting and produce revenue within a certain period of time. Here, the cost of repaying the principal is only one consideration as part of the high cost of capital. It is also necessary to project the amount of interest payments that must be made to investors, as well as the costs of managing the bond issue from the date of creation all the way through to the maturity date.
Other means may be used to manage the high cost of capital, such as using a business line of credit, obtaining a business loan, or even factoring the accounts receivables of an existing business in order to secure the necessary funds now rather than later. With each solution, the effect of the high cost of capital is that those solutions may or may not be feasible, depending on the projected return of the project and the amount of expenses the borrower will incur. For this reason, accurately projecting not only the costs associated with the borrowing but also when and how much return will be realized to manage that debt is very important.
Ideally, the high cost of capital is offset by returns that cover all capital expenses and still leaves a considerable amount of profit for the investors and company owners. Since only those directly involved can decide how much profit is considered acceptable in terms of the risk and expense associated with the endeavor, it is necessary to set specific goals for those returns. If the projected returns will not cover the high cost of capital or are not likely to produce what is considered a reasonable level of profit, choosing to abandon the effort and find a different project would be worthy of consideration.
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