56  Risk and the Cost of Capital 
their risk profile, unless the projects are so large that failure would threaten 
the viability of the entire company. Most executives are reluctant to take on 
smaller risky projects even if the returns are very high. By aggregating projects 
into portfolios, rather than assessing them individually, executives can often 
overcome excessive loss aversion.
Our focus in this chapter will be on key principles. Chapter 15 provides 
detail on how to measure the cost of capital.
Cost of Capital Is an Opportunity Cost
The cost of capital is not a cash cost. It is an opportunity cost. To illustrate, 
when one company acquires another company, the alternative might have 
been to return that cash to shareholders, who could then reinvest it in other 
companies. So the cost of capital for the acquiring company is the price 
investors charge for bearing risk—what they could have earned by reinvest-
ing the proceeds in other investments with similar risk.3 Similarly, when 
valuing individual business units or projects for strategic decision making, 
the correct cost of capital is what a company’s investors could expect to earn 
in other similarly risky projects, not necessarily the whole company. The 
core principle is that the cost of capital is driven by investors’ opportunity 
cost, because the executives leading the company are the investors’ agents 
and have a fiduciary responsibility to the company’s investors.4 That’s why 
the cost of capital is also referred to as the investors’ required return or 
expected return. The meaning of these terms may differ in academia, but 
for the most part you can use cost of capital, required return, and expected 
return interchangeably.
Chapter 15 describes in detail how to estimate a company’s opportu-
nity cost of capital. Most practitioners use a weighted average cost of capital 
(WACC), meaning the weighted average of the cost of equity capital and the 
cost of debt capital.5 For now, it’s enough to say that a company’s cost of eq-
uity capital is what investors could earn by investing in a broad portfolio of 
3 To be more precise, the cost of capital is the return investors can earn from investing in a well-diversi-
fied, “efficient” portfolio of investments with similar risk.
5 The use of WACC is a practical solution. In theory, the opportunity cost of capital is independent of 
capital structure (a company’s amount of debt versus equity) except for the tax benefit of debt. An 
alternative is to estimate the opportunity cost of capital as the company’s cost of equity (what equity 
investors expect to earn) if it had no debt, adjusted directly for the tax benefit of debt. In theory, the two 
approaches should yield the same result.
4 In some countries, executives also have a duty to the “company,” but that concept is typically vaguely 
defined and does not provide executives with much guidance. For the most part, even in those coun-
tries, the opportunity cost for investors is the best calculation to make. In the United States, a recent 
innovation is the “benefit” corporation, whose charter includes additional objectives that executives 
can weigh against the interest of shareholders, including positive impact on society, workers, commu-
nities, and the environment. The concept is relatively new; not many large listed companies are benefit 
corporations, the conversion to which requires a shareholder vote.