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The cost of capital is an expected return that the provider of capital plans to earn on his investment.

Capital (money) used for funding a business should earn returns for the capital providers who risked his/her saved money. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. 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.

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous.

The cost of capital is often used as the discount rate, the rate at which projected cash flow will be discounted to give a present value or net present value.

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