What is the Cost of Capital?

The cost of capital is the blended cost of an entity's currently outstanding debt instruments and equity, weighted by the comparative proportions of each one.

In reviewing new investments in production equipment, a manager wants the projected return to exceed the cost of capital; otherwise, the entity is generating a negative return on its investment. Thus, the cost of capital concept is used extensively in capital budgeting.

The Impact of Interest Rates on the Cost of Capital

The cost of capital tends to increase when interest rates are high, since this boosts the cost of the debt component of an entity's financing mix. When debt is inexpensive, organizations tend to use more debt as a funding source, which drives down their cost of capital. However, when interest rates eventually increase again, the increased debt payment burden can cause some businesses to be in financial difficulties.

How to Reduce the Cost of Capital

There are several ways to reduce the cost of capital, which are as follows:

Take on more debt. The cost of equity is much more expensive than debt in most cases, so a business wanting to reduce the weighted average cost of its capital would logically want to use as much debt as possible. With a lower cost of funds, it is then possible to invest in projects that have lower returns on investment.
Strengthen financial performance. Higher earnings reduce the risk perceived by investors, allowing the business to obtain new equity at a higher price per share. This means that it can obtain the same amount of equity by selling fewer shares.