Cost of capital

Also called: Weighted average cost of capital, WACC · Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT

Meaning

Cost of capital is the return that investors and lenders expect for putting money into a project. Lenders want interest, and shareholders want a return on their equity. When a firm uses both, it calculates the weighted average cost of capital (WACC), which is the average of the two, weighted by how much of each it uses:

WACC = (E/V) × Re + (D/V) × Rd × (1 − t)

Here E is equity, D is debt, V = E + D, Re is the return shareholders expect, Rd is the interest rate on debt and t is the tax rate. Interest is tax-deductible, so debt costs the firm a little less. A project is worth doing only if it earns more than its cost of capital. Riskier projects and riskier countries have to pay a higher cost of capital.

Example

Solar, wind and green hydrogen plants spend most of their money at the start, and their "fuel" (sunlight and wind) is free. That makes the cost of capital a large part of the final price. An OECD–World Bank report (2024) found that if the cost of capital rises from 9% to 20%, the cost of producing green hydrogen can go up by as much as 73%. This is why tools that lower investors' risk, such as loan guarantees and blended finance, can cut costs more than a per-kg subsidy does.

Don't confuse with

• Capital cost: this is the money spent upfront on machines and buildings. Cost of capital is the rate of return that investors demand on that money.
• Coupon rate: this is the fixed interest one bond pays on its face value. Cost of capital covers all of a firm's funding, both debt and equity.

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• Financial Markets, Instruments, Insurance and Pensions