Chapter 19. Determining the Cost of Capital

Many companies make decisions to build new facilities, invest in new machinery, or expend sums for other large projects without any idea of whether the return to be expected from these projects will exceed the cost of capital needed to fund them. As a result, a company may find that it is working furiously on any number of new projects but seeing its ability to generate cash flow to repay debt or pay stockholders decline over time. To avoid this situation, it is necessary to calculate the return on investment, which was covered in Chapters 3 through 5. This chapter discusses the second part of the investment decision, which is the calculation of the cost of capital against which investment decisions must be compared. The chapter describes the primary components of a company’s capital, how the cost of each kind is combined to form a weighted cost of capital, and how this information should be most appropriately used when evaluating the return on new projects that require funding, as well as for discounting the cash flows from existing projects.

Components of the Cost of Capital

Before determining the amount of a company’s cost of capital, it is necessary to determine its components. The following two sections describe in detail how to arrive at the cost of capital for these components. The weighted average calculation that brings together all the elements of the cost of capital is then described in the section that follows these.

The first ...

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