Introduction to Financial Management

COST OF CAPITAL

Cost of capital is defined as the rate of return that is necessary to maintain the market

value of the firm (or price of the firm’s stock).

Managers must know the cost of capital, often called the minimum required rate of
return in:
(1) Making Capital Budging Decisions
(2) Helping to establish the optional capital structure; and
(3) Making decision such as leasing, bond refunding and working capital management

The cost of capital is computed as a weighted average of the various capital

components, which are items on the right hand side of the balance sheet such as debt,

preferred stock, common stock, and retained earnings (Non-spontaneous or

Discretionary Sources) and Spontaneous Sources - not included in the cost of capital: (i)

Accruals (Taxes, Wages, etc.) and (ii) Accounts Payable

o Importance of the cost of capital

a) Maximizing Firm Value implies minimizing costs, including the cost of financing the

firm

b) The cost of capital is required for discounting cash flows for capital budgeting

c) Many other major financial decisions require an estimate of the cost of capital (e.g.,

Leasing, Bond Refunding, and Working Capital Management)

d) The Weighted Average Cost of Capital (WACC) is used as the discount rate for

valuing the firm using free cash flow

The greater the ratios of debt to equity in the financing mix, the greater the leverage.

Leverage refers to the amount of debt financing used i.e. that portion of the fixed costs

which represents a risk to the firm.

Operating leverage: a measure of operating risk refers to the fixed operating costs

found in the firm’s income statement. Financial leverage: a measure of financial risk

refers to financing a portion of the firm’s assets, bearing fixed financing changes in

hopes of increasing the return to the common stockholders. The higher the financial