Cost of capital: What it is and why it matters

Whether you're a startup founder pitching to investors or a finance student trying to wrap your head around valuation, cost of capital is a concept you can't ignore. It’s the backbone of every investment decision, pricing strategy, and corporate finance calculation.

Let’s break it down.

What is cost of capital?

At its core, the cost of capital is the minimum return a business must earn on its investments to satisfy its investors or creditors.

In simple terms:

“It’s the price of using money.”

If a company raises money through debt (like loans) or equity (like issuing shares), the cost of capital is what it owes to those lenders and shareholders for providing funds.

Components of cost of capital

1. Cost of debt (rd)
   This is the interest a company pays on its borrowings.
   Formula:
   Cost of Debt = Interest Rate × (1 - Tax Rate)
   (Because interest is tax-deductible)

2. Cost of equity (re)
   The return expected by equity investors (shareholders).
   Commonly estimated using the CAPM model:
   Re = Rf + β(Rm - Rf)
   Where:

   • Rf = Risk-free rate

   • β = Beta (risk level)

   • Rm = Expected market return

3. Weighted average cost of capital (wacc)
   A blended average of debt and equity costs.
   Formula:
   WACC = (E/V × Re) + (D/V × Rd × (1 - Tax))
   Where:

   • E = Equity value

   • D = Debt value

   • V = Total capital (E + D)

Why it matters

Investment decisions
WACC becomes a benchmark. If an investment’s return is higher than WACC, it adds value. If not, it destroys value.

Valuation
Used in discounted cash flow (DCF) models to bring future cash flows to present value.

Capital structure
Helps companies decide the optimal mix of debt and equity to minimize costs and risks.

Performance analysis
Acts as a hurdle rate. If a project earns less than the cost of capital, it is not worth pursuing.

Real life example

Let’s say a company is:

• 60 percent funded by equity

• 40 percent funded by debt

• Cost of equity = 12 percent

• Cost of debt = 7 percent

• Tax rate = 30 percent

Then:
WACC = (0.6 × 12%) + (0.4 × 7% × (1 - 0.3)) = 7.2% + 1.96% = 9.16%

This means any new project must generate more than 9.16 percent return to make financial sense.

Common misconceptions

“Cost of capital is the same for all companies.”
No. It varies by industry, size, risk, and capital structure.

“Debt is always cheaper than equity.”
While debt has tax benefits, too much debt increases risk, which can raise both debt and equity costs.

Final thoughts

The cost of capital is more than a formula. It is a guiding principle. Whether you’re analyzing startups, evaluating investments, or pitching to venture capitalists, understanding WACC gives you a reality check on whether your ideas are financially sound.

Every rupee of capital has a cost, and ignoring that cost is the most expensive mistake you can make.

Until next time,
Pavit Kaur

[LinkedIn]