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The cost of capital

By RAUSHAN KUMAR







The cost of capital is the minimum expected return a business must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital. It represents the blended financial cost of funding operations through debt and equity. [1, 2, 3]

Key Concepts
  • The Hurdle Rate: Businesses use the cost of capital as a benchmark or "hurdle rate". Any proposed project or investment must generate returns higher than this benchmark to justify the expense and increase the company's value.
  • Investor Perspective: For investors, it is the required rate of return to compensate for the risk of providing capital to a specific enterprise. [1, 8]
Main Components

A firm's overall cost of capital is typically calculated using the Weighted Average Cost of Capital (WACC), which blends two primary funding types:
  1. Cost of Debt: The effective interest rate a company pays on its borrowed funds, such as loans and bonds. Because interest payments are typically tax-deductible, this is usually the cheaper form of capital.
  2. Cost of Equity: The return that shareholders require to compensate for the risk of investing in the company's stock. This is often estimated using the Capital Asset Pricing Model (CAPM) and is generally more expensive than debt. [2, 3, 8, 9, 10]
How It’s Used
  • Capital Budgeting: Guides management in deciding which new projects or strategic acquisitions to pursue.
  • Valuation: Used as a discount rate to estimate the present value of future cash flows when valuing a business or investment.
  • Risk Assessment: Volatile or risky businesses will have a higher cost of capital because investors demand a higher premium to offset that risk. [5, 6, 8, 11, 12]
You can read more about calculating WACC and its specific components on the Corporate Finance Institute or explore comprehensive definitions on Investopedia.


Reference:

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