Definition of cost of capital

Cost of capital

Companies can be financed by lenders (debt) or shareholders (equity). Cost of capital refers to the cost of these forms of capital. See also weighted average cost of capital (WACC). The cost of debt is the interest rate it is charged by the lender, less tax relief. For example, if a company pays interest at 4% and the tax rate is 25%, the after tax cost of debt is 3%. The cost of equity is an opportunity cost. Shareholders expect a reasonable return for the level of risk that they take on an investment. If they do not receive their expected return, they may well sell their shares. So theoretically, to keep shareholders happy, companies must produce returns that meet or exceed shareholder expectations. The return expected by the shareholder is often referred to as the cost of equity. See also CAPM.

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