Difference between Required Return and Cost of Capital

Required Return

The required rate of return is defined as the minimum return that an investor will accept in exchange of owning the stock of the company as compensation for any given level of risk that is associated with holding the company stock. The corporations will also use the required rate of return to analyse the potential profitability of the capital projects.

The required rate of return will also reflect the investor’s point of view in terms of managing the risk. In a nominal sense, the investors can also find a risk free return by holding on to their money; or they can also find a low-risk return by the method of investing in safe assets like cash, money market funds, short-term treasuries or gold.

Risk is also a very important factor in the required return. The riskier assets may offer a higher potential of returns while also providing the investors with a much more favourable ratio of the risk of returns. Many investors use the risk/reward ratios to get a better idea of the expected returns for any investment compared with the amount of risk they must undertake in order to earn these higher returns.

Cost of Capital

The cost of capital is defined as the expected returns on the securities issued by an organisation. Companies use this figure of the total cost of capital to judge whether any project is worth investing in or not. Investors also use this metric to understand whether their investment is worth the actual risk compared to its predicted returns.

Businesses are also concerned with their total cost of capital. It is extremely crucial for any company to determine the timing and amount of capital that they want to raise. In addition to making a decision related to how much cash it needs, a company has to decide the method it will use to acquire the money.

Typically, a firm will have to decide on whether they should issue new stock, go for bonds or take out loans or a line of credit. They will have to make these decisions based on which capital-raising options is the best for their company on an economic as well as strategic basis. Each of these options comes with its own risks and costs. A firm has to weigh the estimated return necessary to make the capital project worthwhile. Knowing the actual cost of capital will also help the company to compare their options to raise the cash much more easily.

Difference between Required Return and Cost of Capital

The required rate of return and the cost of capital are important metrics within finance and investing. These measures also vary in terms of scope, use and perspective. It can also affect the critical investment decisions both for the corporations as well as individual investors. There are several areas of difference between required return and cost of capital which we must discuss below to get a deeper insight into this topic:

Conclusion

Both the cost of capital and the required return are important for any firm while finalising on making financial investments. They have benefits that the stakeholders will have to be aware of. With the right strategy and planning, both the cost of capital and required return will help a company get an understanding of the market apart from achieving stability and growth in the long run.

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