FinTech Glossary

What is Cost of Capital?

Cost of capital is the rate of return a company must earn to justify the cost of financing its operations, investments, or growth. It represents the minimum return required by shareholders and lenders for providing funds to the business. In simple terms, it is the company’s “hurdle rate” for making financially viable decisions.

Business Context

Every business raises money through equity, debt, or a mix of both. Each source comes with a cost: interest on loans or expected returns demanded by equity investors.

The cost of capital helps finance teams evaluate whether a project, acquisition, expansion, or long-term investment will generate returns higher than the cost of capital.

A lower cost of capital means cheaper financing and more favourable conditions for growth. A higher cost indicates increased risk, tightened credit, or reduced investor confidence.

CFOs use cost of capital to guide capital budgeting, pricing decisions, long-term planning, and strategic investments.

Types of Cost of Capital

1. Cost of Debt: The effective interest rate a company pays on its borrowings.
2. Cost of Equity: The return expected by shareholders or investors for investing in the business.
3. Weighted Average Cost of Capital (WACC)

The blended cost of equity and debt is weighted by their share in the capital structure. Formula:

WACC = (E/V × Re) + (D/V × Rd × (1 − Tax Rate))