The Cost of Capital and Hurdle Rates

How companies decide whether an investment is worth making by comparing its expected return with the cost of the money used to fund it.

Every investment a company makes, from a new factory to a software system, uses money. That money is not free. Lenders expect interest, and shareholders expect returns. The cost of capital is the minimum return an investment must earn to satisfy them.

Cost of debt

The cost of debt is the interest rate a company pays on loans and bonds. Because interest is usually tax-deductible, the after-tax cost of debt is lower.

Cost of equity

Shareholders do not receive a fixed interest payment, but they expect a return for taking risk. The cost of equity is usually higher than the cost of debt because shareholders are paid only after lenders and bear more risk. Analysts often estimate it using models such as the capital asset pricing model, which considers the risk-free rate and how risky the company’s shares are compared with the market.

WACC

Companies combine these into the weighted average cost of capital, or WACC. It weights the cost of debt and equity by how much of each the company uses.

For example, if a company is funded 40 percent by debt costing 6 percent after tax and 60 percent by equity costing 14 percent, its WACC is about 10.8 percent.

Hurdle rates

Companies use a hurdle rate, often based on WACC plus a margin for risk, to judge investments:

If a project’s expected return exceeds the hurdle rate, it creates value.
If not, it destroys value, even if it makes an accounting profit.

This connects to net present value: discounting future cash flows at the cost of capital. A positive NPV means the project is worth doing.

Why it matters

Interest rates: when rates rise, the cost of capital rises, and fewer projects pass the hurdle. This is one way monetary policy affects investment.
Riskier projects need higher returns.
Countries: firms in countries seen as risky face higher costs of capital, making investment harder.

The new factory

A company considers a new factory expected to return 9 percent a year. Its WACC is 11 percent. Although the factory would make a profit, it earns less than investors expect, so it would reduce the company's value. The company looks for better projects.

Thinking any profitable project is worth doing

A project must earn more than the cost of capital to create value. Earning less means investors would be better off elsewhere.

Key takeaways

The cost of capital is the minimum return investors require.
WACC combines the after-tax cost of debt and the cost of equity.
Projects must beat the hurdle rate or have a positive NPV to create value.
Higher interest rates raise the cost of capital and reduce investment.