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“If you make investments that don’t get a return that exceeds the cost of capital, you’re encouraging investors to go elsewhere,” explains Knight. So once the finance department, CFO, or treasure department has determined what the rate is, managers know that is the number to beat if they want to win support for their projects or proposals.

“A wise company only invests in projects and initiatives that exceed the cost of capital,” says Knight. Senior leaders use it to evaluate individual investments and investors use it to assess the risk of a company’s equity. There are two ways that cost of capital is typically used. But if the business is looking to stimulate investments, they might lower the rate, even if just for a period of time. A risk-averse company might raise the discount rate even further, as high as 15-20%. And how much they pad it will depend on their appetite for risk. “They’re building in a cushion,” says Knight, which is not a bad thing. For example, a company’s cost of capital may be 10% but the finance department will pad that some and use 10.5% or 11% as the discount rate. In many businesses, the cost of capital is lower than the discount rate or the required rate of return. Then the management team takes that number and decides on the discount rate, or hurdle rate, that you have to exceed to justify an investment,” he says. “At most companies, the cost of capital is a mechanical calculation done by the finance people.

You may be wondering if this is the same as discount rate and the terms are sometimes used interchangeably, explains Knight. Any investment a company makes has to earn enough money that investors get the return they expect and debt holders can be repaid. There are two groups of people who may put up the capital needed to run a business: investors who purchase stock and debt holders who buy bonds or issues loans to the company. “The cost of capital is simply the return expected by those who provide capital for the business,” says Knight. To learn more about this commonly used business term, I spoke with Joe Knight, author of the HBR TOOLS: Return on Investment and co-founder and owner of What is the cost of capital? But are you sure you know exactly what that is? And how your company uses it? You’ll likely be asked to show that the return on the investment will be better than your company’s cost of capital. But before you spend the company’s hard-earned money, you’ve got to prove to your company’s leaders that it’s worth the investment. You’ve got an idea for a new product line, a way to revamp your inventory management system, or a piece of equipment that will make your work easier.