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.
◈ 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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