Cost of capital is the return a firm must provide to attract debt and equity funding, based on the risks and terms involved.
Definition
Cost of capital reflects the expected return required by lenders and owners who provide funding to a business. A calculation may combine the cost of borrowing with the return equity investors expect, weighted according to the funding mix. The inputs and weighting depend on the purpose of the analysis and the assumptions used. In valuation work, a related rate may be used to convert forecast cash flows into present value. Owners may see risk factors such as reliance on a few clients, key people, or uncertain cash flow affect the rate selected by a valuation professional. Cost of capital is not a loan’s interest rate alone, nor is it the firm’s profit margin or a guaranteed return. It is an analytical input whose meaning depends on whether the analysis concerns the whole business, a project, or a particular source of funding.
How owners use it
- Discuss the assumptions behind a discount rate used in a business valuation or investment analysis.
- Compare the cost and terms of debt funding with the return expectations of owners providing equity.
- For example, if debt is 40% of funding at 6% and equity is 60% at 12%, the weighted rate is (0.40 × 6%) + (0.60 × 12%) = 9.6%.
- Consider how business risk assumptions affect the rate used to evaluate projected cash flows.
