Session 1: Introduction to Cost of Capital

Learning Outcomes
At the end of this session, the Learners should be able to have a general understanding of what is meant by a firm capital structure.

Important Terms

• Cost of capital
• Debt
• Equity
• WACC
• MCC
• Break even point

Recall in chapter one, the discount rate used to calculate the present value of future cash flows was generally given. In the real world, of course, the rate is not given, but must be estimated for the particular problem at hand. In this chapter we show how to perform that task for a business firm.

The discount rate represents the capital costs to the firm, or, its cost of capital. In carrying out the analysis the chapter is divided into two distinct sections:

1. Analysis and estimation of the cost of each component of capital, e.g., debt, preferred stock, retained earnings and new common stock capital;
2. Obtaining the weighted average cost of capital (WACC) by averaging these component costs using the firm's optimal capital structure proportions;

By definitions

The cost (stated as a percent per year) the firm must pay investors to

1. Retain capital in the firm, and/or
2. Obtain new capital which can be either Equity or Debt

Note: The term capital represents the funds used by the firm to purchase investment projects.

The firm's cost of capital is also the average investor's minimum required rate of return on his/her invested capital.

Management will always seek to raise capital by the cheapest and most efficient methods, hence minimizing its cost of capital. This will have the effect of increasing the net present value of the company’s projects and ultimately will have an upward effect on its market value.

Example:
Project X, discounted at the firm's cost of capital, has a positive NPV and an IRR greater than the discount rate cost of capital.
Decision-Accept since the project returns at least the required rate of return investors demand on invested capital.

In order for a company to try to minimize its cost of capital, it

1. Requires information on the costs associated with the different ways of raising finance.
2. Needs to know how to combine the different sources of finance in order to reach its optimal capital structure.

A company’s capital comprises of equity and different forms of debt.