THE COST OF CAPITAL
INTRODUCTIONThe project’s cost of capitalis the minimum required rate of return on funds committed to the project, which depends on the riskiness of its cash flows. The firm’s cost of capitalwill be the overall, or average, required rate of return on the aggregate of investment projects 2
COST OF CAPITALThe cost of capital of any investment (project, business, or company) is the rate of return the suppliers of capital would expect to receive if the capital were invested elsewhere in an investment (project, business, or company) of comparable risk•The cost of capital reflects expected return•The cost of capital represents an opportunity cost•The Opportunity Cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk.
SIGNIFICANCE OF THE COST OF CAPITALEvaluating investment decisionsDesigning a firm’s debt policyAppraising the financial performance of top management4
WEIGHTED AVERAGE COST OF CAPITAL (WACC)WACC = wErE+ wprp+ wDrDwE= proportion of equityrE= cost of equitywp= proportion of preferencerp= cost of preferencewD= proportion of debtrD= Post-tax cost of debttc= corporate tax rate
KEY POINTS•Only three types of capital (equity; nonconvertible, noncallable preference; and nonconvertible, noncallable debt) are considered.