Being able to estimate a company's cost of capital is important for several reasons. First recall that creating value is all about cash flow and growing cash flow. Next a company's value can be estimated by calculating the present value of future cash flows (this is what the price of a public company's stock represents) and then combining the present value with any long-term debt and excess cash to obtain an enterprise value. The use of this technique requires that a discount rate be established to discount the future cash flows to a present value. The Weighted Average Cost of Capital is fundamental in this regard.
Well-run companies generally have good cash flow and strong balance sheets with low debt-to-equity ratios and qualify for investment-grade debt ratings. Among other things this means that there is substantial equity and cash flow standing behind the debt, thus greatly reducing the risk associated with the debt to a level where it can be viewed as nearly risk free and thereby fulfilling one of the assumptions that form the basis for the Beta framework.
Taken as a whole, cash flows from projects or investments must provide funds that will pay interest on debt, repay debt in accordance with the debt amortization schedule, provide for any dividends for shareholders the board may declare, and provide cash to reinvest in the business.
The Weighted Average Cost of Capital is also known as a hurdle rate ...
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