The cost of capital represents the minimum rate of return that a firm must earn on its financing sources—debt, preferred stock (if any), and common equity—to satisfy lenders and investors given the risk of the cash flows. In practice, companies often describe it with the weighted average cost of capital (WACC), which combines the after-tax cost of debt with the cost of equity based on the firm’s capital structure. The after-tax cost of debt reflects interest expense deductibility, while the cost of equity captures the return required by shareholders and is frequently estimated with models such as the Capital Asset Pricing Model (CAPM).
In corporate budgeting, the cost of capital is the discount rate used to calculate net present value and to compare prospective projects. A project is evaluated by discounting future cash flows at the cost of capital; if the expected cash flows yield a return that meets or exceeds the cost of capital, the project would typically yield a positive NPV when evaluated at that rate. The concept also informs decisions about financing—whether to issue debt or equity—and about optimizing the overall mix of capital to manage risk and cost.
The cost of capital is not a static figure; it changes with market conditions, interest rates, and a firm’s risk profile. Analysts may assign different costs of capital to different business units or project types to reflect varying risk levels, especially when projects have distinct risk from the corporate average.
The firm discounts expected cash flows at its cost of capital to determine the net present value of a proposed project.
Weighted Average Cost of Capital (WACC) · Discount rate · Net present value (NPV) · Internal rate of return (IRR) · Cost of debt · Cost of equity · Capital budgeting