Cost of Capital The cost of capital

Cost of Capital The cost of capital is the opportunity cost of investing in an asset relative to the expected return on assets of similar risk. Inventory is an asset; consequently, we should use a cost measure that adequately reflects the firm’s approach to financing assets. Most firms use the weighted average cost of capital (WACC), which is the average of the required return on a firm’s stock equity and the interest rate on its debt, weighted by the proportion of equity and debt in its portfolio. The cost of capital usually is the largest component of holding cost, as high as 15 percent of inventory value, depending on the particular capitalization portfolio of the firm. Firms typically update the WACC on an annual basis because it is used to make many financial decisions.