Cost of Capital

The cost of capital is a company's weighted average, after-tax cost of all the funding sources it uses to finance itself, combining the cost of its debt, preferred stock, common stock, and retained earnings into a single blended figure. It represents the minimum rate of return a company should expect to earn on a new investment or project for that investment to be worth undertaking, since any return below the cost of capital would actually destroy value for the company's investors rather than create it.

The most widely used version, the weighted-average cost of capital, multiplies the cost of each financing source by the proportion that source represents in the company's overall capital structure, then sums the results. The after-tax cost of debt is used rather than the stated interest rate, since interest payments are generally tax-deductible, which lowers the true cost of borrowing to the company by the amount of tax saved. The cost of equity, whether common or preferred stock, is harder to observe directly than the cost of debt, since equity investors do not receive a contractually fixed payment, and is typically estimated using models such as the capital asset pricing model, which ties the required return to the stock's risk relative to the broader market.

Companies use their cost of capital as the discount rate in net present value calculations when evaluating whether to undertake a new project, and as the hurdle rate a proposed investment's expected return must clear before it is considered worth pursuing. A project expected to earn less than the company's cost of capital is, in effect, expected to destroy value, since it would not generate enough return to adequately compensate the lenders and shareholders who provided the financing for it, even if the project appears profitable on a simpler, undiscounted basis.

A company's cost of capital rises with the riskiness of its business and its capital structure: riskier businesses must offer lenders and equity investors a higher expected return to compensate for the greater uncertainty, and a company that relies heavily on debt faces a higher risk of financial distress, which can push up both its cost of debt and its cost of equity as leverage increases. Prevailing interest rates in the broader economy also feed directly into the cost of capital, since both the cost of new debt and typical equity return expectations tend to rise and fall with overall market interest rate levels.

The cost of capital is a threshold, not a target: a company's actual return on investment on a given project needs to exceed the cost of capital for that project to create value, and the gap between the two — sometimes expressed through a measure like economic value added — is a common way analysts judge whether management is genuinely creating value for shareholders or merely growing the business without improving its underlying returns. A company that consistently earns returns below its own cost of capital, even while growing revenue, is effectively destroying shareholder value with every new investment it makes.