The cost of capital is the minimum required rate of return, a project must earn in order to cover the cost of raising funds being used by the firm in financing of the proposal. This can be substantiated as follows: if a firm accepts an investment proposal, it will also need funds for its raising. These funds can be procured from different types of investors i.e., equity share holders, preference share holders, debt holders, depositors etc. These investors while providing the fund to the firm will have an expectation of receiving a minimum return from the firm. The minimum return expected by the investors depends upon the risk perception of the investors as well as on the risk return characteristics of the firm. Therefore in order to procure funds, the firm must pay this return to the investors. Obviously, this return payable to the investors would be earned out of the revenues generated by the proposal wherein the funds are being used. So, the proposal must earn at least that much, which is sufficient to pay to the investors of the firm. This return payable to investors is therefore, the minimum return the proposal must earn otherwise, the firm need not take up the proposal. In nutshell, therefore, the cost of raising funds is the minimum required rate of return of the firm i.e., the cost of capital is the minimum return which the firm must earn on the proposals in order to break-even.

Thus, the minimum rate of return that a firm must earn in order to satisfy the expectation of its investors is called the cost of capital of the firm. In other words, the cost of capital is the rate of return, a firm must earn in order to attract the supplier of funds to make available the funds to the firm.              

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