Cost of Capital
The minimum return a company must earn on a project to justify the money tied up in it - typically calculated as a blend of the cost of debt and the cost of equity (the WACC).
Key takeaways
- Cost of capital is the minimum return a company must earn to justify an investment.
- It sets the hurdle rate for evaluating projects and opportunities.
- It is normally calculated as the Weighted Average Cost of Capital (WACC) - a blend of the cost of debt and the cost of equity.
- Riskier projects typically require a higher cost of capital.
In plain English
Cost of capital is the price tag on the money a company uses. Every pound deployed in a project has to earn back at least that price - otherwise the business would be better off using the cash to pay down debt or returning it to shareholders.
It's a blend because most companies finance themselves with a mix of debt (loans, bonds) and equity (shareholder money). Debt has an explicit interest cost; equity has an implicit one - the return shareholders expect for taking the risk of owning the business.
Why it matters for solar
When a CFO compares a solar investment against, say, expanding a factory, the cost of capital is the common yardstick. Both projects must beat the same hurdle to be worth the cash they consume. This is why the discount rate on the Solar ROI dashboard is set to the business's cost of capital - it's the fairest test of whether the system genuinely creates value.
Cost of capital vs. discount rate
The two are often used interchangeably, but strictly the cost of capital is calculated by finance teams as a breakeven figure, and management then sets a discount rate (or hurdle rate) on top of it that the project must beat to be approved.