What is the cost of capital?

The cost of capital refers to the return rate that a company must earn to satisfy its investors. This concept is essential in finance as it signifies the opportunity cost of making a specific investment versus the returns that could be earned from alternative investments with similar risk levels. The cost of capital encompasses both the cost of equity and the cost of debt, representing the minimum return that a company needs to make investments worthwhile for its shareholders and lenders.

When a company is evaluating potential projects or investments, it measures their anticipated returns against the cost of capital. If the expected return on an investment exceeds the cost of capital, it generally indicates a good opportunity to create value for shareholders. Conversely, if the return is below the cost of capital, the investment could destroy value.

Understanding the cost of capital is crucial for making informed financial decisions, optimizing capital structure, and ensuring that the firm remains attractive to existing and potential investors.