Business Valuation Glossary
Cost of Capital Model
Definition
A way of estimating the required rate of return on a business investment such as small business ownership.
What It Means
The Cost of Capital represents the measure of the risk associated with a business investment. Put differently, it is the cost to the business of attracting and retaining the capital necessary to conduct its operations.
This cost is determined in a competitive market since business owners must choose among the alternative investments based on each investment’s risk and return profile. A Cost of Capital Model is a way to measure the return required to compensate the business owners for the risk they take.
There are a number of Cost of Capital Models that are widely used by investors. The most common ones include:
- Arbitrage Pricing Theory Model (APT)
- Build-Up Model
- Capital Asset Pricing Model (CAPM)
- Discounted Cash Flow Model
- Fama-French Three Factor Model
The Cost of Capital Models are important in calculating the so-called discount rate and capitalization rate which are used in business valuation under the Income Approach.