In one sentenceThe average the business pays for its funds from loans and owners' money, weighted by the share of each source; it is the minimum acceptable return from any project.
Simply put
A loan has an obvious cost, the interest, and the owners' money has a cost too even though it is not paid: the return the owners expect in exchange for the risk. The cost of capital is their weighted average by each one's share of the financing.
If a project earns a return lower than this cost, it eats into the value of the business even if a profit appears in the income statement.
Worked example
A factory is financed with 600,000 SAR from the owners, who expect 15% on it, and a 400,000 SAR loan at 8% interest (ignoring the effect of Zakat and tax for illustration).
Owners' share = 600,000 ÷ 1,000,00060%
Loan share = 400,000 ÷ 1,000,00040%
60% × 15% + 40% × 8% = 9% + 3.2%12.2%
Weighted average cost of capital12.2%
Formula: (Owners' share × their required return) + (debt share × cost of debt)
Don't confuse it with
Paid-up capitalPaid-up capital is an amount in equity, and the cost of capital is a rate expressing the price of all the financing.