Cost of Capital in 2025: Recalibrating Hurdle Rates After Two Years of High Interest Rates

The New Rate Environment

For most of the decade between 2012 and 2022, the Bank of England base rate sat at or near historic lows. At its nadir in 2020 and 2021, the base rate was 0.1%. UK government gilts (the risk-free rate proxy most commonly used in CAPM calculations) yielded less than 1% across most maturities. The cost of equity for even a high-risk growth business was suppressed by this ultra-low risk-free rate, and the cost of debt was similarly compressed.

That environment ended abruptly. From late 2021, the Bank of England began a sustained hiking cycle to combat inflation, eventually reaching a peak base rate of 5.25% in August 2023. By January 2025, despite some modest cuts, the base rate remained at 4.75%, and 10-year gilt yields were approximately 4.5% to 4.8%. This represents a risk-free rate roughly 4 percentage points higher than the pre-2022 environment.

The implications for the cost of capital are not merely additive. Because the risk-free rate appears in every component of WACC (both the cost of equity via CAPM, and the cost of debt, which is priced as a spread over the risk-free rate), a rise in the risk-free rate has a compounding effect across the entire capital structure. The era of cheap capital is over, and CFOs who are still running financial models with pre-2022 discount rate assumptions are materially undervaluing risk.

Building WACC: The Components

WACC is the blended cost of all capital in the business, weighted by the proportion of each source in the capital structure. The formula is:

WACC = (E/V) × Ke + (D/V) × Kd × (1 - T)

Where E is the market value of equity, D is the market value of debt, V is total value (E + D), Ke is the cost of equity, Kd is the cost of debt, and T is the corporate tax rate. For an equity-funded growth business with no debt, WACC simplifies to the cost of equity. For a business with both debt and equity, the tax shield on debt (interest is tax-deductible) reduces the after-tax cost of debt, which is why debt is generally cheaper than equity in WACC terms.

Calculating the Cost of Equity: CAPM

The Capital Asset Pricing Model (CAPM) is the standard method for estimating the cost of equity:

Ke = Rf + β × (Rm - Rf)

Where Rf is the risk-free rate, β (beta) is the sensitivity of the asset's returns to market returns, and (Rm - Rf) is the equity risk premium (ERP), the additional return that investors demand for holding equities rather than risk-free assets.

Each component has been materially affected by the rate environment:

• Risk-free rate (Rf): in January 2025, the 10-year gilt yield is approximately 4.6%. In January 2021, it was approximately 0.3%. This alone adds 4.3 percentage points to the cost of equity, before any other adjustments.
• Equity risk premium (ERP): the ERP has historically averaged around 4.5% to 5.5% for UK equities (Damodaran estimates approximately 5.0% for the UK as at early 2025). Some argue the ERP has compressed as rates have risen (investors require less additional return when risk-free rates are themselves higher), but for most practical purposes a figure of 4.5% to 5% is appropriate.
• Beta: for a listed fintech, a beta of 1.2 to 1.8 is typical, reflecting above-market risk. For an unlisted growth business, an additional size/illiquidity premium of 2% to 4% is often applied.

The Cost of Debt in 2025

The cost of debt is more straightforward to observe for companies with existing debt facilities. For a growth-stage fintech, the cost of debt will typically be a base rate (SONIA or base rate) plus a credit spread. In January 2025, with a base rate of 4.75% and a typical growth company credit spread of 3% to 5%, the pre-tax cost of debt ranges from approximately 7.75% to 9.75%.

After applying the corporation tax shield (at 25% for companies above the small profits threshold), the after-tax cost of debt is approximately 5.8% to 7.3%. This is the figure that enters the WACC calculation. Compared to 2021, when a similar after-tax cost of debt might have been 2% to 3%, the cost of debt has roughly tripled.

A Worked WACC Example

Consider a Series B fintech with £15m of equity value and £3m of debt outstanding. The capital structure is 83% equity, 17% debt. Using the figures derived above:

2021 WACC: (0.83 × 11%) + (0.17 × 2.5%) = 9.1% + 0.4% = approximately 9.5%

2025 WACC: (0.83 × 15%) + (0.17 × 6.5%) = 12.5% + 1.1% = approximately 13.6%

This 4 percentage point increase in WACC is not a minor calibration. It is the difference between many projects being value-accretive and being value-destructive.

The NPV Impact: What This Means for Investment Decisions

The relationship between discount rate and NPV is non-linear, particularly for long-duration cash flows. Consider a project with the following cash flow profile: an upfront investment of £1,000,000, followed by annual cash inflows of £200,000 per year for eight years.

This NPV sensitivity is most pronounced for projects where the cash flows are back-end loaded (infrastructure investments, platform buildouts, long sales cycle products) because the high discount rate penalises distant cash flows most severely. Short payback period projects are less affected by discount rate changes. In the current environment, there is a rational case for preferring investments with faster payback profiles over long-duration strategic bets.

Fintech Valuation Multiple Compression

The increase in discount rates directly explains the compression in revenue and EBITDA multiples seen across the fintech sector from 2022 to 2024. A DCF model is the fundamental driver of equity value, and when the discount rate rises, the intrinsic value of a given cash flow stream falls.

In simple terms: if a business is valued on a revenue multiple, that multiple is implicitly derived from assumptions about long-run margins and a terminal growth rate, discounted at WACC. As WACC rises, the implied multiple falls. A business growing at 30% with a 15% long-run free cash flow margin might have warranted a 15x revenue multiple at a 9% WACC. At 14% WACC, the same business on the same assumptions might support only a 9x to 10x multiple.

This is not sentiment or market irrationality. It is arithmetic. CFOs who frame the valuation correction as a market problem rather than a discount rate problem misdiagnose the issue and draw the wrong strategic conclusions.

Setting Hurdle Rates in the Current Environment

Hurdle rates are the minimum acceptable return on investment used in capital allocation decisions. Most CFOs set a single hurdle rate derived from WACC, with adjustments for project risk. In the current environment, the process of setting hurdle rates deserves explicit board-level attention.

Practical Implications for Capex Planning

The higher cost of capital environment changes the optimal approach to several common capital allocation decisions faced by growth companies.

Build vs buy decisions shift toward buy when the cost of capital is high, because buying an existing capability avoids the long ramp period of internal development during which capital is committed but returns are not yet materialising. At low discount rates, the NPV difference between building and buying narrows; at high discount rates, the present value of early cash flows in a buy scenario becomes relatively more attractive.

Timing of large infrastructure investments deserves re-examination. An investment with a payback period of seven years that was marginal at 9% WACC is likely negative-NPV at 14% WACC. The appropriate response is not to abandon the project indefinitely, but to sequence it: invest in the phase with the fastest payback first, demonstrate returns, and re-evaluate the longer-duration phases as the rate environment potentially eases.

Leasing versus purchasing becomes relatively more attractive for lessees when the cost of capital rises, because buying requires committing capital at the full purchase price today whereas leasing distributes payments over time. IFRS 16 restores much of the balance sheet impact of leasing, but the cash flow timing advantage of leasing is real and increases in value as discount rates rise.

Communicating to the Board

The CFO's role in this environment is to bring analytical rigour to capital allocation decisions and ensure the board understands that the investment decision framework has changed. Three practical actions are worth taking before the next board strategy session:

1. Update your WACC formally. Document the components (Rf, ERP, beta, size premium, cost of debt) and present the current WACC alongside the 2021 equivalent. The delta will often surprise board members who have not worked through the arithmetic.
2. Rerun your capex pipeline at the current WACC. Any project in the pipeline that was approved pre-2022 should be re-evaluated. The project may still be attractive, but the decision should be confirmed with updated assumptions rather than grandfathered.
3. Set explicit hurdle rates by category. Subjective investment decisions are harder to challenge consistently. A board-approved hurdle rate schedule creates a clear, auditable basis for capital allocation and avoids the common trap of approving marginal projects under pressure during budget season.

Key Takeaways

• The UK risk-free rate has risen from approximately 0.3% in early 2021 to approximately 4.6% in early 2025. This flows directly into every cost of capital calculation via CAPM.
• For a typical growth fintech, WACC has risen from approximately 9% to 10% in the zero-rate era to approximately 13% to 15% in the current environment, before any company-specific changes.
• NPV is highly sensitive to discount rate for long-duration projects. Projects that were strongly positive at 8% WACC may be marginally negative or negative at 14% WACC with identical cash flows.
• Revenue multiple compression in the fintech sector from 2022 to 2024 is the direct arithmetic consequence of higher discount rates, not simply a change in sentiment.
• Hurdle rates should be set explicitly by project risk category, reviewed annually, and approved by the board. The zero-rate era hurdle rates are now inadequate.
• Build vs buy, timing of capex, and leasing versus purchasing decisions all shift in meaningful ways as the cost of capital rises. Each should be re-evaluated with current rate assumptions.
• The CFO's role is to translate the macro rate environment into specific, actionable implications for the company's investment pipeline and capital allocation framework.