The minimum rate of return a company must earn on its investments to satisfy its debt holders and equity shareholders.
Cost of Capital represents the blended cost of all funding sources (debt and equity) that finance a company's operations. It's the hurdle rate for investment decisions — any project must earn above this rate to create shareholder value. The Weighted Average Cost of Capital (WACC) combines the after-tax cost of debt and the cost of equity, weighted by their proportion in the capital structure. Cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM), while cost of debt is the interest rate adjusted for tax savings.
Company has ₹60,00,000 equity (cost 14%) and ₹40,00,000 debt (interest 10%, tax rate 25%). WACC = (60/100 × 14%) + (40/100 × 10% × 0.75) = 8.4% + 3.0% = 11.4%. Any new project must earn >11.4% return to be worth pursuing.
Ensures accurate financial reporting and record-keeping
Helps maintain regulatory and tax compliance
Enables better-informed business decisions
Improves operational efficiency and cash flow management
Equity holders take more risk than debt holders — they get paid last (after interest and principal), have no guaranteed returns, and lose everything in bankruptcy. Debt interest is also tax-deductible, further reducing its effective cost. Higher risk demands higher expected return.
Cost of capital is the discount rate in Discounted Cash Flow (DCF) valuation. A higher cost of capital means future cash flows are worth less today, reducing company valuation. Lowering your cost of capital (through optimal capital structure) directly increases company value.
The use of borrowed funds (debt) to finance business operations, amplifying both potential returns and risks for equity shareholders.
A financial ratio comparing a company's total debt to its shareholders' equity, measuring how much the business relies on borrowed money versus owner investment.
A financial metric that measures the profitability of an investment by comparing the net profit to the cost of the investment, expressed as a percentage.
The residual interest in the assets of a business after deducting all its liabilities. Also called owner's equity, net worth, or shareholders' equity.
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