3.18 Summary: The Cost of Capital

A firm’s cost of capital was shown to be the weighted average of its various component costs. Capital components consist of debt and equity.

If capital component costs rise, the Weighted Average Cost of Capital will rise as well. The rise in the WACC will make fewer projects acceptable under our capital budgeting guidelines; each will now have higher capital costs!

To be sure, the subject of valuation cannot be discussed without some treatment of the notion of market efficiency and the Capital Asset Pricing Model. We have assumed that market prices reflect the true, intrinsic values of financial assets, and that the market pricing mechanism indeed works. This is to say that we assume that markets are “efficient.” In reality, this subject is far more nuanced than as it has been presented herewith.

Soon, we will review the “external funds needed” model, which is intended to enable the corporation to predict how much external capital is required to support the company’s near-term growth plans. Now that we understand this role and the notion of cost of capital in its entirety, we may turn to the issue of capital structure, which addresses the question of how much of the external capital requirement should be raised from debt or equity. Indeed, we shall address the questions of how a firm’s capital structure is determined by its management, and what is the ideal singular capital structure (or debt-to-equity ratio)?