Financial Management: Principles and Applications, 13/e

14.1 The Cost of Capital: An Overview

In this chapter, we will examine the relationship between risk and expected return from the perspective of the firm. Indeed, we can view the returns that investors expect to receive on the firm’s stocks and bonds as the cost to the firm of attracting the capital used to fund the firm’s investments in its assets.

We can think of the cost of capital for a firm as a weighted average of the required rates of return of the securities that are used to finance its business. We refer to this as the firm’s weighted average cost of capital, or WACC. The WACC incorporates the required rates of return demanded by the firm’s lenders and investors along with the particular mix of financing sources that the firm uses. Most ...