99Forum - Discussion Forums - Message Board Forum

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital.
The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modelled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous.
The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the risk-weighted projected return required by investors, where the return is largely unknown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar risk profiles to determine the "market" cost of equity.
Once cost of debt and cost of equity have been determined, their blend, the weighted-average cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate for a project's projected cashflows.

rate of return that is necessary to maintain market value (or stock price) of a firm, also called a hurdle rate, cutoff rate,or minimum required rate of return.The firm's cost of capital is calculated as a weighted average of the costs of debt and equity funds. Equity funds include both capital stock (common stock and preferred stock) and retained earnings. These costs are expressed as annual percentage rates. The cost of capital is the cost of a company's funds (both debt and equity), or, from an investor's point of view "the expected return on a portfolio of all the company's existing securities".[1] It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.