Finance term
Cost of Capital
Also known as: WACC, weighted average cost of capital, blended cost of funds
Definition
Cost of capital is the weighted average rate a business pays for its capital across all debt and equity sources. It is the minimum hurdle rate for investments — any project must generate returns exceeding the cost of capital to create value.
Detailed explanation
Cost of capital (often expressed as WACC — Weighted Average Cost of Capital) blends the after-tax cost of each capital source weighted by its proportion in the capital structure. The formula: WACC = (E/V × Re) + (D/V × Rd × (1 − T)), where E = equity value, D = debt value, V = total capital (E + D), Re = cost of equity, Rd = pre-tax cost of debt, T = corporate tax rate.
For small businesses, the cost of capital framework is most practically useful as a decision hurdle: if a business can borrow at 8% (WACC), any investment must return more than 8% to be value-accretive. Taking a $100K equipment loan at 8% to buy equipment that generates $6K/year in extra profit is value-destructive (6% < 8% WACC). The same loan funding equipment generating $12K/year is value-accretive.
Debt is typically cheaper than equity — interest expense is tax-deductible, reducing the after-tax cost of debt. For a business paying 10% interest with a 25% effective tax rate, the after-tax cost of debt is 10% × (1 − 0.25) = 7.5%. Cost of equity has no tax shield — equity investors require higher expected returns to compensate for residual risk after debtholders are paid.
For small business owners who self-fund from retained earnings, the relevant cost of equity is the opportunity cost of that capital — what return could you earn by investing it elsewhere at similar risk? Ignoring opportunity cost leads to underpricing of growth investments funded from cash on hand.
The Federal Reserve's H.15 release puts the Bank Prime Loan rate at 6.75% as of September 4, 2026 (Federal Reserve, https://www.federalreserve.gov/releases/h15/) — the benchmark most variable-rate SBA and bank business loans price directly off (Prime plus a lender spread), making it the single biggest lever on a small business's cost of debt capital right now. In FY2025 the SBA guaranteed 77,600 loans through its 7(a) program and another 6,750 loans through its 504 program (https://legacy.sba.gov/article/2025/09/30/trump-sba-delivers-record-capital-small-businesses-fy25) — most 7(a) loans carry a variable rate tied to this same Prime rate.
◈ Worked example
- Capital structure: $500K bank debt at 8%, $200K owner equity. After-tax debt cost: 8% × (1−0.25) = 6%. Cost of equity: 15% (owner's required return). WACC = (500/700 × 6%) + (200/700 × 15%) = 4.3% + 4.3% = ~8.6%
- Investment hurdle: equipment generating 12% return vs. 8.6% WACC — value-accretive, fund it
- MCA at 40% factor-rate APR — well above any reasonable WACC; only justifiable if the immediate revenue opportunity return exceeds 40%
Common questions
The most-asked questions about Cost of Capital — answered straightforwardly.
Why is debt cheaper than equity in cost of capital? +
Interest on business debt is tax-deductible, giving debt an after-tax cost advantage. Additionally, debt is senior to equity in the repayment waterfall — debtholders accept lower returns because they face less risk than equity holders. Equity holders, bearing residual risk, require higher expected returns.
How should I use cost of capital when evaluating a business loan? +
Compare the loan's cost (APR, after tax benefit) to the expected return on what you'll fund with it. If borrowing at 9% (after-tax ~6.75%) to fund an expansion that returns 15%, cost of capital supports the investment. If borrowing at 9% to fund something returning 5%, it destroys value — don't do it without a strategic rationale beyond pure ROI.
What's a typical small business cost of capital? +
Varies widely by industry, leverage, and risk profile. A stable, established small business with bank debt at 7–9% and modest leverage might have WACC of 10–14%. A higher-risk, faster-growing business with alternative financing might have WACC of 20%+. Cost of capital rises with financial risk and business risk.
Further reading
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