Cost of capital

Cost of capital is the return a company must provide to compensate investors and lenders for supplying funds. It reflects the required returns on its financing sources, weighted by their shares of total capital.

Weighted average cost of capital: A company’s average financing cost, weighting debt and equity costs by their shares of total capital. This is the standard calculation combining a company’s debt and equity costs.
Discounted cash flow: A valuation method that estimates an asset’s value by discounting expected future cash flows. The cost of capital often provides the discount rate for valuing a company’s operating cash flows.
Adjusted present value: A valuation method that values an investment as if all-equity financed, then adds financing effects separately. It separates operating value from financing effects instead of embedding them in one weighted rate.
Investment decision: A choice about committing resources to an asset or project in expectation of future benefits. A higher required return can make fewer projects pass a company’s acceptance threshold.
Cost of equity: The return shareholders require for investing in a company’s equity. It supplies the equity component of a company’s overall financing cost.
Net present value: The present value of expected cash inflows minus the present value of expected cash outflows. Projects are commonly accepted when their net present value is positive using an appropriate cost of capital.
Internal rate of return: The discount rate that makes an investment’s net present value equal zero. It is a project-return measure compared with a required return, not the company’s financing cost itself.
Firm valuation: The estimation of a company’s economic value using its assets, earnings, or expected cash flows. Higher discount rates generally reduce the present value of expected future cash flows.
Cost of debt: The effective interest rate a company pays on borrowed funds, adjusted for relevant tax effects when used in valuation. It supplies the debt component, often reduced by the tax deductibility of interest.
Capital budgeting: The process of evaluating and selecting long-term investments. A company compares expected project returns with the relevant cost of capital.

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