Cost of Capital (COC) is a critical concept in understanding firm value, defined as that rate of return (return on investment) an investor must receive to entice the investor to commit capital to the proposed investment.
Owners of companies must understand the important role cost of capital plays in transaction value determination. Owners focus on company value in terms of the amount that can be obtained in a sale transaction (Transaction Value or Transaction Price). However, the sale of a company can be a complex dynamic. An investor considers alternative investments on a comparative risk-return basis. A sales transaction requires not only a seller, but also a buyer who is willing to buy/invest in a company and will consider alternative investments that may carry less risk and even greater return (Return on Investment, “ROI”).
Two points of understanding regarding cost of capital are critical:
- First, an investor’s cost of capital limits the amount an investor will pay for a company or any other investment.
- Second, if the seller’s desired transaction value yields a return less than the buyer’s cost of capital, it is unlikely a sale transaction will occur.
We will return to cost of capital and its implications when we journey to “EBITDA” and “Multiples” Ports of Call.
Noise, Cost of Capital, EBITDA and Multiples will be explored regarding how they are connected and interact and their importance in understanding firm value will be discussed.
Investors must make their required rate of return (return on investment “ROI”) or they will not invest.