What does "cost of capital" refer to?

The concept of "cost of capital" represents the overall cost of funding a business through different sources, which typically include both debt and equity. This cost is crucial for businesses as it essentially reflects the opportunity cost of investing capital in one type of investment over another. Investors expect to receive returns that compensate them for the risk they undertake by providing capital.

When a company raises funds through debt, it incurs interest costs, and when it uses equity, it may need to provide returns to shareholders in the form of dividends or capital gains. The cost of capital is therefore a blended rate that indicates the required return on investments, guiding firms in making financial decisions that maximize shareholder value. It plays a fundamental role in capital budgeting, as businesses use it to evaluate which projects or investments yield returns that exceed this cost.

Understanding this concept is essential for anyone involved in finance, investment, or business management, as it underpins decisions related to funding and investment strategy.