What Is Cost of Capital?

Cost of capital is a foundational concept in corporate finance and FP&A. Every investment decision implicitly compares the expected return against the cost of the capital used to fund it. If returns exceed the cost of capital, value is created. If they fall short, value is destroyed.

The cost of equity is the return shareholders require for investing in the company. It is not directly observable and must be estimated, typically using the Capital Asset Pricing Model (CAPM) or by reference to the company's dividend yield plus expected growth rate (Gordon Growth Model). The cost of equity is always higher than the cost of debt because equity holders bear more risk.

The cost of debt is the effective interest rate a company pays on its borrowings. Unlike equity, this is directly observable from loan agreements and bond yields. After adjusting for the tax deductibility of interest, the after-tax cost of debt is typically the cheapest source of capital.

FP&A teams use cost of capital in multiple ways. As a discount rate for investment appraisal (NPV, IRR analysis). As a benchmark for performance measurement (does ROIC exceed the cost of capital?). As an input to valuation models (DCF analysis). And as a basis for setting hurdle rates for capital budgeting.

For UK companies, the cost of capital reflects UK-specific factors: gilt yields for the risk-free rate, the UK equity risk premium, sector-specific betas for listed companies, and current bank lending rates for the cost of debt. The Bank of England base rate significantly influences the cost of debt across the UK economy.