Basics of cost of capital

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor's opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor's opportunity cost), investors will not invest in the firm's debt and equity. As a result, the firm's value (both their debt and equity) will decline.

Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm's bonds and stocks.

If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profitability of different investments. When there are differences in the degree of risk between the firms a risk-adjusted discount-rate approach should be used to determine their profitability. Different hurdle rates are sometimes used because firms are not homogeneous in terms of risk. Finance theory and practice tells us that investors require higher returns as risk increases.
A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.
The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors.
Cost of capital (WACC)=
(Cost of Equity x Proportion of equity from capital)+ (Cost of debt x Proportion of debt from capital)+ (Cost of Preference share x Proportion of preference share from capital).
Equity includes retained earnings and the cost of R/E is taken at cost of equity. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses. In case of preference shares, the dividend rate can be taken as the cost since it is the amount, which the company intends paying against preference shares. As is the case of debt the issue expenses or discount/premium on issue has also to be taken into account.
Thus cost of capital is used to evaluate the project. It is also know as discount rate.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

Please see the attached file.