When defining the cost of capital, it's useful to frame it from either the borrower's point of view (i.e. the organization) or the lender's point of view (the investor). For the organization borrowing the capital, the cost of capital is the cumulative rate of interest (usually derived as an average rate, combining all capital inputs) applied to the borrowed capital to fund a project. From the investor's point of view, the cost of capital is the relative required return rate considering the risk of the investment being made.

If this all sounds a bit confusing, don't worry. Here's an overview of the most important concepts:

Net Present Value (NPV)

The reason that capital incurs interest revolves around the simple fact that time has an impact on the valuation of capital, presenting opportunity costs and risk. To take into account the present value of future cash flows is therefore an important aspect of anticipating the rate of return on an investment. An NPV calculation will look at the forecasts for future cash flows, and discount those into present day dollars based on a given interest rate. This allows investors and organizations to determine if the cost of capital will be offset by the profits of a given investment.

Required Rate of Return

From the investor's point of view, every investment has a required rate of return for (generally) two reasons: the opportunity cost of foregone investments and the risk of the borrower defaulting on payments. For example, if an investor can get 10% return on an investment with exactly the same risk as an option with 12% return, the investor would incur an opportunity cost of 2% by investing in the 10% return option. Similarly, if two investments both yield a 10% return but present different levels of risk, an investor would make the decision based on the lowest risk option.

Cost of Debt

As an organization, one of the options for sourcing capital is to pursue debt. This can either be through taking out a loan or putting selling corporate bonds. These options tend to have lower interest rates, and long payback periods. Debt is paid back first in the case of bankruptcy, lowering it's risk as an investment (and subsequently, lowering it's return). The cost of this capital is calculated as:

${\displaystyle K_{D}=(R_{f}+{\text{credit risk rate}})(1-T)}$

R_f is the risk-free rate and T is the corporate rate. Tax is included in debt as debt is discounted as a deductible expense.

Cost of Equity

Equity, usually represented as shares of stock, is another option for borrowing (and investing) at the organizational level. Equity's cost is calculated via the capital asset pricing model (CAPM), as follows:

${\displaystyle E_{s}=R_{f}+\beta _{s}(R_{m}-R_{f})}$

The variables above are:

• E_s is the expected return for a security
• R_f is the expected risk-free rate
• β_s is the sensitivity to market risk
• R_m is the historical return of the market
• (R_m – R_f) is the risk premium compared to the risk-free rate

Weighted Average Cost of Capital

With the above options in mind, the weighted average cost of capital (WACC) normalizes the cost of capital by combining the interest rates being incurred from both debt and equity. It can be written as:

${\displaystyle {\text{WACC}}={\frac {D}{D+E}}K_{d}+{\frac {E}{D+E}}K_{e}}$

While each of these concepts is quite a bit more complex in implementation, this overview gives some scope as to the general definition and considerations involved in the cost of capital. Capital incurs costs due to risk, return, and the intrinsic time value of money.