What does 'cost of capital' mean?

The term 'cost of capital' refers specifically to the return that investors expect to receive for providing capital to a company. This concept is crucial in investment decision-making and financial management, as it represents the minimum return that must be earned on an investment to satisfy the investors. It essentially serves as a benchmark for evaluating potential investment projects.

When companies consider various funding sources, they analyze the cost of capital to ensure that any new investments or projects they undertake are expected to generate returns that exceed this cost. If an investment does not provide a return higher than the cost of capital, it could be seen as unwise, as it doesn't add value to the firm and could even diminish investor wealth.

Incorporating the cost of capital into decision-making processes helps firms to align their growth strategies with investor expectations, making it a fundamental concept in corporate finance and investment management.