What does the cost of capital refer to?

The cost of capital refers to the overall cost of funding a company incurs through both debt and equity financing. This measure is crucial for businesses as it represents the minimum return that investors expect for providing capital to the company. This expectation of return is integrated into investment decisions and financial performance assessments.

When assessing projects or investments, companies evaluate whether the anticipated returns exceed the cost of capital to determine their viability. The cost of capital incorporates the weighted average of all funding sources, balancing the relative costs of equity (which may include dividends and retained earnings) and debt (interest payments on loans), allowing for a more holistic view of a company's financing expenses.

This comprehensive understanding enables companies to make informed financial decisions and ensures that they maintain sustainable growth by meeting or exceeding the expectations of their capital providers.