Cost of capital definition

The cost of capital is the blended cost of an entity's currently outstanding debt instruments and equity, weighted by the comparative proportions of each one.

In reviewing new investments in production equipment, a manager wants the projected return to exceed the cost of capital; otherwise, the entity is generating a negative return on its investment. Thus, the cost of capital concept is used extensively in capital budgeting.

The cost of capital tends to increase when interest rates are high, since this boosts the cost of the debt component of an entity's financing mix. When debt is inexpensive, organizations tend to use more debt as a funding source, which drives down their cost of capital. However, when interest rates eventually increase again, the increased debt payment burden can cause some businesses to be in financial difficulties.