FAU FIN 3403 Cost of Capital (Student) - The Weighted...

The Weighted Average Cost of Capital
Cost of Capital – the cost that a firm must pay for the capital it uses to finance new
investments and investment projects.
Capital comes from:
1) Debt
2) Preferred stock
3) Retained earnings
4) Common stock
Alternatively:
Cost of Capital to the firm is the equilibrium rate of return demanded by investors in the
capital markets for securities in that risk class. So, it is the minimum rate of return
required on new investments undertaken by the firm.
The role of cost of capital in capital budgeting:
If IRR on New Investment > Cost of Capital  This is a positive NPV project  Value of
firm rises  Stock Price rises.
If IRR on New Investment < Cost of Capital  This is a negative NPV project  Value
of firm falls  Stock Price falls.
Why is the Cost of Capital equal to the return investors require?
Because when the investors give the firm their money, they expect to earn a return
commensurate with the risk of that project or firm. Therefore, at a minimum the firm
must earn at least the Expected Return, E(R), that investors require. So the E(R) from the
Capital Asset Pricing Model (CAPM) (and similar models) becomes the minimum rate
that the firm must earn to satisfy investors and this rate becomes one component of the
relevant discount rate used in capital budgeting decisions.
Computing the Cost of Capital for Each Component
Cost of Equity Capital (Common Stock)
Recall the CAPM

 
j RF M RF j
B R R R R E    ) (
Where:
j
R is the return on the
th
j
stock,
RF
R is the return on the Risk Free asset,
M
R is the return on the market,
j
 is the measure of systematic risk.