Arizona State University FINANCE 300 Fundamentals of Finance Chapter 10: Cost of Capital Instructor: Christian Ramirez Introduction In the last two chapters we learned that the cost or price of debt was interest and the cost of equity was the rate of return stockholders demand on their investments. These two forms of capital financing are two ways companies obtain the necessary funds to grow and expand their operations. In this chapter, we begin by describing the cost of capital and explaining the logic of the Weighted Average Cost of Capital (WACC). We next explain how to estimate the cost of each component of capital, and how to put the components together to determine the WACC. We will close out this chapter explaining the factors that influence a company’s WACC. Cost of Capital The goal of any company is to maximize shareholders’ value, or the stock’s price value. One way to accomplish this is by investing in projects that earn more than the cost of capital, or the cost that the company must pay to obtain capital. This capital cost can be in the form of interest payments to bond holders if the company uses debt capital or dividend payments to stockholders if they raise equity capital. A company’s cost of capital equals to the investor’s required rate of return. These investors can be stockholders if the company uses equity to raise capital, or bondholders if debt capital is raised. For example, suppose a company plans to build a new food processing facility. This company figures that it can issue bonds to finance the new facility at a cost of 10% (this 10% represents the interest payments of the bonds). In order for the company to break even on this project, the earnings generated from this new plant should at least be the same as the cost of issuing bonds, or the cost of debt capital. However, nobody likes to just break even and companies will like to get a higher return than their cost of capital. During this and the following chapter, we will refer to the cost of capital or the required rate of return as the hurdle rate . The hurdle rate is the minimum rate of return that must be met for a company to undertake a particular project. In other words, if a company is considering borrowing at 10% (cost of debt capital) to build a new facility, the total present value of the expected cash flows of this new facility must generate a return higher than 10% in order for the company to accept this project. Sources of Long-term Capital
Companies will use three main forms of capital as their source for long-term financing. These three forms of capital are Debt, Preferred Stock, and Common Equity (New Common Stock & Retained Earnings). Therefore, we say that a company’s cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the company uses to finance its assets.