Final answer:
The cost of capital is referred to as the minimum expected return necessary for an investment to be considered viable and represents the opportunity cost of choosing a particular investment over others with a similar risk profile. It includes a risk premium, indicating the required extra return for riskier investments.
Step-by-step explanation:
The cost of capital is often referred to as the minimum expected return an investment must offer to be attractive. It serves as a benchmark that an investment must exceed for it to be considered worthwhile. In a way, it represents the opportunity cost of investing in real assets instead of financial assets that carry the same level of risk.
For a financial investor, selecting an interest rate for evaluating future payments is a critical decision. This rate should reflect the return on alternative investment opportunities, accounting for the opportunity cost of investing financial capital. Additionally, the investor should include a risk premium if the investment is perceived to be riskier than average - indicating that a higher rate of return is required to justify the investment.
To illustrate, if a financial investor determines that the appropriate interest rate to value future payments is 15%, this suggests a comparison against other investments offering similar risk is being made. If the rate is indicative of the cost of capital, any potential project or asset requiring capital should ideally return more than 15% to be deemed a viable investment.
When a company considers new projects, it has to assess whether the project's return overcomes this cost of capital. If a firm can combine its cost of capital with societal returns, as in the example where a 9% cost of capital is offset by a 5% return to society, its effective rate of return is reduced, influencing investment decisions substantially.