Cost of Capital
BeginnerThe cost of capital is the minimum return a company must earn on its investments to satisfy the people who provide its funding, its lenders and shareholders.
Money is never free. Lenders expect interest, and shareholders expect a return, through dividends and a rising share price, that rewards them for the risk they take. The cost of capital is the return needed to meet these expectations.
It is often calculated as a weighted average of the cost of debt and the cost of equity, known as the weighted average cost of capital (WACC). A company financed partly by cheap debt and partly by more expensive equity has a cost of capital somewhere in between.
The cost of capital acts as a benchmark. If a company's cost of capital is 8% and a new project is expected to return 12%, the project should add value. If it returns only 6%, it destroys value, because investors could earn more elsewhere for similar risk.
The cost of capital depends on risk. Stable businesses with predictable cash flows usually have a lower cost of capital than young or volatile ones. It also changes with interest rates: when rates rise, both debt and equity become more expensive.
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