Every source of finance has a “price”. Debt has interest; equity expects dividend and capital appreciation. The cost of capital is the minimum return a company must earn on its investments to satisfy its providers of funds. In capital budgeting, cost of capital is used as the discount rate for NPV and as the hurdle rate to compare with IRR.
You should be able to:
Cost of capital is the required rate of return that a firm must earn on its investments so that the market value of the firm is maintained (concept). It represents the opportunity cost of using funds in a project rather than in the next best alternative.
Simple exam line: It is the minimum acceptable return (hurdle rate).
Importance (write any 5):
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Components (any three):
Any three components are acceptable.
Meaning/use (any three):
Hence, it guides investment and financing decisions.
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Every source of finance has a “price”. Debt has interest; equity expects dividend and capital appreciation. The cost of capital is the minimum return a company must earn on its investments to satisfy its providers of funds. In capital budgeting, cost of capital is used as the discount rate for NPV and as the hurdle rate to compare with IRR.
You should be able to:
Cost of capital is the required rate of return that a firm must earn on its investments so that the market value of the firm is maintained (concept). It represents the opportunity cost of using funds in a project rather than in the next best alternative.
Simple exam line: It is the minimum acceptable return (hurdle rate).
Importance (write any 5):
Debt cost is based on interest rate. In many syllabi, you mention the after-tax idea because interest is tax-deductible (concept).
Basic expression (concept):
Equity does not have fixed interest, but shareholders expect return. At an intro level, Ke is often explained as the return required by equity investors (concept).
Common ways (conceptual mention):
Preference shares generally carry a fixed dividend rate. Kp is the cost of that preference dividend (concept).
WACC is the overall cost of capital computed as the weighted average of the costs of different sources (debt, equity, preference etc.), where weights are based on their proportion in total financing.
Interpretation: WACC is the firm’s average required return; projects should typically earn returns above WACC to create value (concept).
Identify sources (D, E, P) → Find component costs (Kd, Ke, Kp) → Compute weights (wd, we, wp) → Multiply and add: WACC = wd×Kd + we×Ke + wp×Kp → Interpret as hurdle rate
Assume:
WACC = (0.40 × 8%) + (0.60 × 12%)
= 3.2% + 7.2% = 10.4%
Interpretation: the company should target returns above 10.4% on average (concept).
Common factors:
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Cost of capital is the minimum required return expected by providers of funds.
Cost of capital acts as a hurdle rate for investment decisions and a guide for financing structure (concept).