Cost of capital and weighted average cost of capital: determining the hurdle rate for investments

Graziano Stefanelli
Aug 18
3 min read

The cost of capital represents the minimum rate of return a company must earn on its investments to satisfy its providers of capital—both debt holders and equity investors.

It serves as the hurdle rate in capital budgeting, determining whether a project creates or destroys shareholder value.

The most widely used measure in corporate finance is the Weighted Average Cost of Capital (WACC), which blends the costs of debt and equity according to their proportions in the company’s capital structure.

Breaking down the cost of capital into components.

A company typically finances itself through a mix of debt, equity, and sometimes preferred stock.

Each source of funding has its own cost, influenced by market conditions, company risk profile, and tax effects.

Component	Calculation Basis	Key Influences
Cost of Debt (Kd)	After-tax interest rate paid on borrowings	Credit rating, market interest rates, debt maturity profile
Cost of Equity (Ke)	Required return by shareholders, often estimated using the Capital Asset Pricing Model (CAPM)	Risk-free rate, equity beta, market risk premium
Cost of Preferred Stock (Kp)	Dividend per share ÷ Market price per share	Dividend stability, market perception of risk

CAPM formula for cost of equity:

Ke = Rf + β × (Rm − Rf)Where:

Rf = Risk-free rate (e.g., government bond yield)
β = Beta, measuring stock volatility relative to the market
Rm = Expected market return

Weighted Average Cost of Capital formula.

WACC = (E / V) × Ke + (D / V) × Kd × (1 − Tax rate) + (P / V) × Kp

Where:

E = Market value of equity
D = Market value of debt
P = Market value of preferred stock
V = Total capital (E + D + P)
Ke = Cost of equity
Kd = Cost of debt (after-tax)
Kp = Cost of preferred stock

Example:

If a company is 60% equity-financed (Ke = 12%), 30% debt-financed (Kd = 6%), and 10% preferred stock (Kp = 8%), with a 25% tax rate:

WACC = (0.6 × 0.12) + (0.3 × 0.06 × 0.75) + (0.1 × 0.08)WACC = 0.072 + 0.0135 + 0.008 = 9.35%

Using WACC as the investment hurdle rate.

Capital budgeting: WACC is used as the discount rate for NPV calculations. Projects with expected returns above WACC are value-accretive.
Performance evaluation: Compares return on invested capital (ROIC) to WACC to determine if capital is being deployed efficiently.
Valuation: Serves as the discount rate in discounted cash flow (DCF) models.

Example:

If WACC is 9.35% and a project’s expected return is 11%, it creates value; if expected return is 8%, it destroys value.

Factors influencing WACC over time.

Market interest rates: Rising rates increase cost of debt.
Company risk profile: Higher perceived risk raises cost of equity.
Capital structure shifts: Changes in debt-to-equity ratio affect weighting.
Tax policy: Altered corporate tax rates impact after-tax cost of debt.

Factor	Impact on WACC
Higher interest rates	↑ Cost of debt → ↑ WACC
Improved credit rating	↓ Cost of debt → ↓ WACC
Higher equity volatility	↑ Beta → ↑ Cost of equity → ↑ WACC
Increase in debt proportion	Potential ↓ WACC (tax shield) until distress risk increases

Best practice in managing the cost of capital.

Companies actively manage WACC by optimizing their capital structure, locking in favorable borrowing rates, and improving operational stability to lower perceived risk.

WACC should be reviewed periodically to reflect changes in market conditions, strategic priorities, and financing mix.

Under US GAAP and IFRS, while WACC is not directly reported, it underpins impairment testing, fair value measurements, and internal capital allocation decisions—making it one of the most critical metrics in corporate finance.

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