Cost of Capital

Cost of capital is the minimum return a company or project must earn to justify using investors' money. It is the price of capital — what providers of debt and equity demand for the risk they bear. If a project's return is below the cost of capital, it destroys value even if it is profitable in accounting terms. If the return is above it, the project creates value. Every dollar of capital has a hurdle.

The cost of capital has two main components: cost of debt (interest rate, adjusted for tax shield) and cost of equity (the return equity investors require). Debt is usually cheaper than equity because creditors have priority in bankruptcy and interest is tax-deductible. Equity is more expensive because residual claimants bear more risk. The weighted average cost of capital (WACC) blends both by their proportion in the capital structure. WACC is the hurdle rate for investment decisions: accept projects that earn more than WACC; reject or improve those that don't.

The number is not observable in the market — it must be estimated. Cost of equity is often derived from models (e.g. CAPM: risk-free rate plus beta times equity risk premium). Cost of debt can be inferred from yields on the company's bonds or from comparable issuers. The estimate is sensitive to assumptions: risk-free rate, beta, equity risk premium, and leverage. Small changes in inputs can move WACC by hundreds of basis points. The discipline is to use a consistent, defensible method and to test decisions against a range of cost-of-capital assumptions.

For founders and operators, the cost of capital is the opportunity cost of the money you deploy. If you could earn 10% elsewhere at similar risk, then 10% is your hurdle. Deploying capital at 6% destroys value. The model forces the question: what return do we need, and does this use of capital clear that bar?