What is meant by the cost of capital?

The cost of capital refers specifically to the return that a company needs to earn on its investments to satisfy its investors and maintain its market value. This concept encompasses both equity and debt financing, reflecting the risks associated with investing in the company.

Investors expect a certain return based on the perceived risk of the investment, and if the company's returns fall short of these expectations, its market value may decline. Therefore, the cost of capital acts as a benchmark for evaluating potential investments or projects; if the expected return on a new project is higher than the cost of capital, the project is likely to add value to the company.

Options related to total costs or debt financing alone do not capture the broader perspective of what cost of capital represents, which includes the necessary return on all forms of financing, not just one particular type. In contrast, expenses incurred in raising capital do not encompass the ongoing required returns expected by investors. Thus, focusing on the expected return needed on investments accurately reflects the overarching purpose of the cost of capital in maintaining and increasing market value.