The Cost Of Capital Introduction - Financial Management

One of the key variables in capital expenditure analysis is the cost of capital. This chapter discusses the concept of the cost of capital and develops approaches that can be used to measure this important variable.

The cost of capital is concerned with what a firm has to pay for the capital—that is, the debt, preferred stock, retained earnings, and common stock—it uses to finance new investments. It can also be thought of as the rate of return required by investors in the firm’s securities. As such, the firm’s cost of capital is determined in the capital markets and is closely related to the degree of risk associated with new investments, existing assets, and the firm’s capital structure. In general, the greater the risk of a firm as perceived by investors, the greater the return investors will require and the greater will be the cost of capital.

The cost of capital can also be thought of as the minimum rate of return required on new investments undertaken by the firm.If a new investment earns an internal rate of return that is greater than the cost of capital, the value of the firm increases. Correspondingly, if a new investment earns a return less than the firm’s cost of capital, the firm’s value decreases. This chapter discusses the weighted cost of capital and its use in the capital budgeting process. The nature of the risk versus required return trade-off made by investors in a firm’s securities and the measurement of the cost of individual capital components (debt, common equity, and preferred stock) are also presented.


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