As was discussed in Chapter 7, valuation of a company requires knowledge of the cost of capital. Cost of capital is the opportunity cost a company incurs to secure funds for investment. From an investor’s point of view, cost of capital is that rate of return on investment which makes the discounted stream of future earnings equal to the supply price of the asset. This chapter is concerned with the meaning and method of estimating cost of capital.
Estimating cost of capital requires calculation of the components of the cost of capital: equity, debt, and preferred stocks. We discuss the components and methods of calculating them next.
Cost of Equity
To calculate the cost of equity or required rate of return on stock, we ...