Fundamentals of Financial Management (Concise 6th Edition)

C r e a t i n g Va l u e a t GE

(^10) The Cost of Capital

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General Electric (GE) is one of the world’s best-

managed companies, and it has rewarded its

shareholders with outstanding returns. GE cre-

ates shareholder value by investing in assets that

earn more than the cost of the capital used to

acquire them. For example, if a project earns

20% but the capital invested in it costs only 10%,

taking on the project will increase the firm’s

1-4 Stock Prices and Shareholder Value

Capital is obtained in three primary forms:

debt, preferred stock, and common equity, with

equity acquired by retaining earnings and by the

issuance of new stock. The investors who pro-

vide capital to GE expect to earn at least their

required rate of return on that capital, and the

required return represents the firm’s cost of

capital.^1 A variety of factors influence the cost of

capital. Some—including interest rates, state

and federal tax policies, and general economic

conditions—are outside the firm’s control. How-

ever, the firm’s decisions regarding how it raises

capital and how it invests those funds also have

a profound effect on its cost of capital.

Estimating the cost of capital for a company

such as GE is conceptually straightforward. GE’s

capital comes largely from debt plus common

equity obtained by retaining earnings, so its cost

of capital depends largely on the level of interest

rates in the economy and the marginal stock-

holder’s required rate of return on equity. How-

ever, GE operates many different divisions

throughout the world; so the corporation is simi-

lar to a portfolio that contains a number of differ-

ent stocks, each with a different risk. Recall that

portfolio risk is a weighted average of the rele-

vant risks of the different stocks in the portfolio.

(^1) Recall from earlier chapters that expected and required returns as seen by the marginal investor must be equal; otherwise,
the security will not be in equilibrium. Therefore, buying and selling will force this equality to hold, except for short periods
immediately following the release of new information. Since expected and required returns are normally equal, we use the
two terms interchangeably.
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