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Cost of Capital: Getting it Right

Analyze the various ways to determine the cost of capital and determine which is the most difficult to get right.

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Generally speaking, the cost of capital is misunderstood. It is NOT the historical cost of funds, such as the coupon rate for bonds, or the initial cost for raising equity plus any dividends declared. Instead it represents an OPPORTUNITY COST which is the rate at which investors would provide financing for any capital budget project which is currently being evaluated. If historical costs were to be used, the analysis could be very wrong if market rates have changed over time.

In an efficient capital market, there is ONLY ONE expected/required rate of return for a given risk level within the efficient capital market. Any differential in returns for comparable investment activity will most likely be eliminated due to arbitrage activity. Another issue to deal with is the differences in risk. The current cost of capital usually reflects the the average risk of ALL of the assets of the firm (also called the portfolio). However, the new project may prove to be very different from this average.

So, the cost of capital is the required return for the capital project. Any required return for an investment is the MINIMUM amount of return that an investor will expect to earn in order to be willing to help finance that investment today. This, when management acts in the best interests of the shareholder, the cost of capital will equate to the required return of the project --- which is the return that investors could earn today given comparable market securities or investment ...

Solution Summary

This report analyzes and defines the cost of capital as it relates directly to future investment opportunities. It also provides a framework for understanding how decisions are made relative to the risk element of an investment, as well as to the rules of finance governing investment projects.