What is Cost of Capital?
The minimum return a business must earn to satisfy everyone who funded it.
What is Cost of Capital?
Cost of capital is the rate of return an entity must earn on its investments to maintain the market value of its equity and meet the expectations of its providers of finance. It is computed as the weighted average of the costs of each source of funding — equity, preference and debt — weighted by their proportions in the capital structure. As the discount rate in investment appraisal, it is the hurdle that a project must clear to create value.
At a glance
Components
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Think of it like…
Think of the interest on money you borrowed from several friends on different terms. One lent at a fixed rate, another wants a share of the profits, a third wants repayment before everyone else. Your business has to earn at least the blended cost of all those promises before any of the gain is genuinely yours.
How Cost of Capital works
- Compute each component cost. Cost of equity via a dividend or risk-based model, cost of debt net of tax, and cost of preference from its fixed dividend.
- Apply the tax shield to debt. Interest is deductible, so the effective cost of debt is the pre-tax rate multiplied by one minus the tax rate.
- Determine the weights. Market values are theoretically preferable to book values; state which you have used and why.
- Combine into WACC. Multiply each component cost by its weight and sum. This becomes the discount rate for appraising projects of similar risk.
A simple WACC computation
- 1Equity 60% at a cost of 15% → 0.60 × 15% = 9.0%
- 2Debt 40% at a pre-tax cost of 10%, tax rate 30%
- 3After-tax cost of debt = 10% × (1 − 0.30) = 7%
- 4Debt contribution = 0.40 × 7% = 2.8%
- 5WACC = 9.0% + 2.8% = 11.8%
Where it shows up
- Capital budgeting. WACC is the discount rate for computing net present value on projects of average risk.
- Capital structure decisions. The mix that minimises WACC is theoretically the optimal capital structure.
- Business valuation. Discounted cash flow valuation depends directly on the discount rate chosen.
- Performance measurement. Economic value added compares returns earned against the cost of the capital employed.
Common mistakes
- Using the pre-tax cost of debt in the WACC computation
- Mixing book value weights with market value component costs without saying so
- Applying a single WACC to a project whose risk differs materially from the firm's
- Forgetting that flotation costs affect the cost of newly issued capital
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Talk to usWhy is debt cheaper than equity?
Because interest is tax deductible and lenders rank ahead of shareholders on winding up, so they bear less risk and demand a lower return. Both effects reduce the cost of debt relative to equity.
Should weights be at book value or market value?
Market value weights are theoretically preferable because they reflect current claims on the firm. Exam questions may specify one — state clearly which basis you have used.
Can WACC be used for every project?
Only for projects of similar risk to the firm's existing operations. A project of materially different risk needs a risk-adjusted discount rate instead.
Understanding Cost of Capital is the start. Using it in a question is the test.
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