Cost of capital
Broadly, the rate of return on a firm’s investments which is required to service the providers of the firm’s capital.
Often the term is used in a more specific sense to refer to the weighted average cost of capital of a business.
For example if a firm's cost of capital is 8%, it must earn a return of at least 8% on its operational investments in order to provide the investors with the minimum investment return of 8% which they require.
The concept of cost of capital is important because when inferior rates of return are earned from operational investments - for example only 5% compared with a cost of capital of 8% - such operations are destructive of shareholder value and need to be improved or discontinued.
The results of these operations may appear (wrongly) to be profitable, when considered in simplistic historical cost financial accounting terms.
See also
- Capital
- Discount rate
- Discounted cash flow
- Gearing
- Opportunity cost
- Opportunity cost of capital
- Shareholder value
- Tax shield
- Weighted average cost of capital
