Corporate Finance Theory and Practice, Third Edition

Chapter 30

THE COST OF CAPITAL

Mirror, mirror on the wall…

Determining the cost of capital, or the weighted average cost of capital, is not a simple task, but it is one of the fundamentals of finance. The cost of capital has to be factored into investment decisions because it is the rate that is used for discounting cash flows for NPV or comparing with the IRR. Cost of capital is also used to determine enterprise value (see Chapter 32). Truly, its importance can hardly be understated.

But before reading on, it is imperative to understand the distinction between cost of capital, which is the weighted average cost of the capital contributed to the firm, and the cost of equity, which is just one component of the weighted average of the cost of capital.

Section 30.1

THE COST OF CAPITAL AND THE RISK OF ASSETS

The cost of capital is the minimum rate of return on the company's investments that can satisfy both shareholders (the cost of equity) and debtholders (the cost of debt). The cost of capital is thus the company's total cost of financing.

When markets are in equilibrium, any investor with a perfectly diversified portfolio holds a fraction of both the company's equity and its debt. This is known as the CAPM, as was discussed in Chapter 19. In other words, each investor holds a share of the company's operating assets, since this is equal to the sum of equity and net debt. Accordingly, each investor has some exposure to the risk arising from the company.

The rate of return required ...