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Health & Fitness

Cost of Capital?

What is Cost of Capital?

Cost of capital is a term being thrown around quite a bit in the news recently to explain some of the stock market activity, the merger mania that has seized the pharmaceutical and bio-tech field, and why technology firms like Facebook are trading at 50 times earnings.

But what exactly is cost of capital, and how does it impact businesses and your personal finances?

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Cost of capital is, in essence, how much it costs a business or individual to obtain financing, or to borrow funds. Whether you are corporation borrowing money or retaining a portion of your earnings, or an individual who is sitting on cash in a bank account, the general principle is the same. The cost of your capital is how much sitting on those funds is costing you, and how expensive it would be to get more capital. In theory when the cost of capital is low (such as now with low interest rates) the idea would be that both organizations and individuals would be freely spending and investing money.

The problem is they are not – so what is the disconnect?

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In an excellent interview, with a link to great piece by Clayton Christensen (of Harvard Business School), an argument is made that finance itself is the problem. With a focus on shorter-term financial metrics and ratios, Christensen argues that a total overhaul of finance is needed to better capture market realities.

What do you think?

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