Cost of Capital
The minimum return a company must earn on its investments to satisfy all capital providers — both debt holders and equity investors.
What is Cost of Capital?
The cost of capital is the weighted average return that a company must generate to meet the expectations of its lenders and shareholders. It represents the opportunity cost of investing in the business: if the company cannot earn at least its cost of capital, it is destroying value. The most common measure is the Weighted Average Cost of Capital (WACC), which blends the after-tax cost of debt and the cost of equity, weighted by each component's share of the total capital structure. The cost of debt equals the interest rate on borrowings adjusted for the tax shield (interest is tax-deductible). The cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM). The cost of capital is the discount rate used in DCF valuations, capital budgeting decisions (projects must earn above the cost of capital), and economic profit calculations (EVA = NOPAT minus cost of capital × invested capital).
Example
A retailer has a capital structure of 40% debt at 5% pre-tax and 60% equity with a CAPM-estimated cost of 10%. At a 21% tax rate, the after-tax cost of debt = 5% × (1 − 0.21) = 3.95%. WACC = (0.40 × 3.95%) + (0.60 × 10%) = 1.58% + 6.00% = 7.58%. Any project returning less than 7.58% destroys value; any project above it creates value for shareholders.
Source: Brealey, Myers & Allen — Principles of Corporate Finance, 13th ed.