Cost of Capital


Cost of Capital


Key Concepts and Skills

• Know how to determine:

– A firm’s cost of equity capital

– A firm’s cost of debt

– A firm’s overall cost of capital

• Understand pitfalls of overall cost of capital and how to manage them



From our modules on capital budgeting, we learn that the discount rate, or required return, on an investment

is a critical input. However, we haven’t discussed how to come up with that particular number. This module

brings together many of our earlier discussions dealing with stocks and bonds, capital budgeting, and risk

and return. Our goal is to illustrate how firms go about determining the required return on a proposed

investment. Understanding required returns is important to everyone because all proposed projects must

offer returns in excess of their required returns to be acceptable.


In this module, we learn how to compute a firm’s cost of capital and find out what it means to the firm and

its investors. We will also learn when to use the firm’s cost of capital and, perhaps more important, when

not to use it.


Why is it important? A good estimate is required for:


• good capital budgeting decisions—neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate

• financing decisions—the optimal/target capital structure minimizes the cost of capital • operating decisions—cost of capital is used by regulatory agencies in order to determine the “fair”

return in some regulated industries (e.g. utilities)





Slide 3



Chapter Outline

• The Cost of Capital: Some Preliminaries

• The Cost of Equity (RE)

• The Costs of Debt (RD) and Preferred Stock (RP)

• The Weighted Average Cost of Capital (WACC)

• Divisional and Project Costs of Capital


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