The cost of capital is the rate of return that an investor expects to earn on his or her investment. If an investment is to be worthwhile, the expected return on capital must be greater than its cost. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.
Cost of capital is made up of two elements: debt and equity. The cost of debt is, in the simplest terms, the amount of interest paid on the debt. The interest cost is historical, but investor expectations may also influence the actual cost (i.e. investors may accept a higher cost in the short term where the long-term gains are better). Other factors may also affect the cost of debt. The interest rate usually includes the risk-free rate plus a risk component, which takes into account the probability of default on the debt.
The cost of equity is more complex. The traditional calculation used is that of dividend capitalization, whereby the dividends per share are divided by the current market value of the stock plus the dividend growth rate. Thus, the cost of equity is equal to the compensation demanded by the market in exchange for ownership of the asset and bearing the risk of ownership.
The weighted average cost of capital (WACC) is a method of measuring a company’s cost of capital. The total capital is taken to be the value of a company’s equity (if there are no outstanding warrants and options, this is equal to the company’s market capitalization) plus the cost of its debt (this must be continually updated as the cost of debt changes every time there is a change in the interest rate). When calculating the WACC, the equity in the debt-to-equity ratio is the market value of all equity, rather than the shareholders’ equity on the balance sheet.
The hurdle rate is the minimum rate of return, when applying a discounted cash flow analysis, that an investor requires before they commit to an investment. A company may apply it when deciding whether to undertake a project, or a bank when extending loans. It must be equal to the incremental cost of capital. It is known as the hurdle rate because the amount of return determines if the investor is “over the hurdle” and ready to invest.
Using a hurdle rate can help take the emotion out of making a decision on investment by focusing purely on the financial aspects. When an investment looks exciting, it can be easy to overlook the risks or a potentially poor rate of return. A risk premium can be appended to the hurdle rate if evaluation of the investment shows that specific opportunities inherently contain high levels of risk.
A major downside to using a hurdle rate is that, inevitably, some profitable projects will be rejected. Additionally, if the hurdle rate is too high, a company may only favor projects that are profitable in the short term rather than taking a long-term view. Thus it can make companies seem conservative and deter them from investing in innovation where the returns are uncertain.