Investment decisions Chapter 9 The cost of capital
9.1 Overview of the cost of capital
Cost of capital – represents the firm’s cost of financing and is the minimum rate of return that a
project must earn to increase firm value.
Investments with a rate of return above the cost of capital will increase the value of the firm.
Investments with a rate of return below the cost of capital will decrease the value of the firm.
The basic concept
A firm’s cost of capital:
- reflects the expected average future cost of funds over the long run
- reflects the entirety of the firm’s financing activities
Most firms attempt to maintain an optimal mix of debt and equity financing.
To capture all of the relevant financing costs, assuming some desired mix of financing, we need to
look at the overall cost of capital rather than just the cost of any single source of financing.
Example:
A firm is currently faced with an investment opportunity. Assume the following:
Best project available today
- Cost = $100,000
- Life = 20 years
- Expected Return = 7%
Least costly financing source available
- Debt = 6%
Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the
opportunity.
Imagine that 1 week later a new investment opportunity is available:
Best project available 1 week later
- Cost = $100,000
- Life = 20 years
- Expected Return = 12%
Least costly financing source available
- Equity = 14%
In this instance, the firm rejects the opportunity, because the 14% financing cost is greater than the
12% expected return.
What if instead the firm used a combined cost of financing?
Assuming that a 50–50 mix of debt and equity is targeted, the weighted average cost here would be:
(0.50 6% debt) + (0.50 14% equity) = 10%
With this average cost of financing, the first opportunity would have been rejected (7% expected
return < 10% weighted average cost), and the second would have been accepted
(12% expected return > 10% weighted average cost).
9.1 Overview of the cost of capital
Cost of capital – represents the firm’s cost of financing and is the minimum rate of return that a
project must earn to increase firm value.
Investments with a rate of return above the cost of capital will increase the value of the firm.
Investments with a rate of return below the cost of capital will decrease the value of the firm.
The basic concept
A firm’s cost of capital:
- reflects the expected average future cost of funds over the long run
- reflects the entirety of the firm’s financing activities
Most firms attempt to maintain an optimal mix of debt and equity financing.
To capture all of the relevant financing costs, assuming some desired mix of financing, we need to
look at the overall cost of capital rather than just the cost of any single source of financing.
Example:
A firm is currently faced with an investment opportunity. Assume the following:
Best project available today
- Cost = $100,000
- Life = 20 years
- Expected Return = 7%
Least costly financing source available
- Debt = 6%
Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the
opportunity.
Imagine that 1 week later a new investment opportunity is available:
Best project available 1 week later
- Cost = $100,000
- Life = 20 years
- Expected Return = 12%
Least costly financing source available
- Equity = 14%
In this instance, the firm rejects the opportunity, because the 14% financing cost is greater than the
12% expected return.
What if instead the firm used a combined cost of financing?
Assuming that a 50–50 mix of debt and equity is targeted, the weighted average cost here would be:
(0.50 6% debt) + (0.50 14% equity) = 10%
With this average cost of financing, the first opportunity would have been rejected (7% expected
return < 10% weighted average cost), and the second would have been accepted
(12% expected return > 10% weighted average cost).
