Understanding Return on Capital and Cost of Capital

This simple but essential video explains the financial concept of the return on capital and the cost of capital. A very useful nugget of information for beginners in corporate finance, financial analysis, financial valuation and financial modeling.

In the simplest and most basic financial terms, the cost of capital is the amount of interest that you pay to borrow the capital required to invest in the business or project. The return on capital is the ratio of the amount of profit you net out of a business or project versus the total amount of capital that you have invested.

For instance if you borrowed a million dollars of capital for a business or project, and your annual interest rate was 7%, your cost of capital for one year will be 7%. If you then invested that one million dollars in your business or project, and generated a net profit of one hundred thousand dollars in a year, your return on capital for that one year will be 10% ($100,000 divided by $1 million).

The key point of this video is that the return on capital should always exceed the cost of capital in order for you to proceed with deciding that the project or business that you are assessing will be a good investment.

The video uses an example of small business investment to illustrate this concept: investing in a restaurant business versus investing in a beauty parlour.

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