What does 'cost of capital' signify?

The correct understanding of 'cost of capital' relates directly to the return required by investors for their investment risk. This concept is crucial in finance as it represents the minimum acceptable return on an investment that compensates investors for the risk they undertake by providing capital to the business.

When a company seeks funding, it can source capital through equity (issuing shares) or debt (taking loans). Each source of capital has an associated cost, which reflects the expected return demand by those investing in or lending to the business. For equity investors, the cost of capital is often linked to dividends and capital gains, while for debt, it is represented by interest payments. A company must earn at least this cost of capital on its investments to satisfy its investors and maintain its market value.

This metric is essential for making informed financial decisions, evaluating opportunities, and determining which projects to pursue to enhance shareholder wealth.