Foundations of Financial Management: An Analysis (part 44)

“If you live for having it all, what you have is never enough.” 

– Vicki Robin

Cost of Capital (part F)

by

Charles Lamson

Summary

The cost of capital for the firm is determined by computing the costs of various sources of financing and weighting them in proportion to their representation in the capital structure. The cost of each component in the capital structure is closely associated with the valuation of that source, which we studied in the last several posts. For debt and preferred stock, the cost is directly related to the current yield, with debt adjusted downward it to reflect the tax-deductible nature of interest.

We weigh the elements in the capital structure in accordance with our desire to achieve a minimum overall cost. While that is usually the cheapest form of financing, excessive debt use may increase the financial risk of the firm and drive up the costs of all sources of financing. The wise financial manager attempts to ascertain what debt component will result in the lowest overall cost of capital. Once this has been determined, the weighted average cost of capital is the discount rate we use in present-valuing future flows to ensure we are earning at least the cost of financing.

The marginal cost of capital is also introduced to explain what happens to a company's cost of capital as it tries to finance a large amount of funds. First the company will use up retained earnings, and the cost of financing will rise as higher-cost new common stock is substituted for retained earnings in order to maintain the optimum capital structure with the appropriate debt-to-equity ratio. Larger amounts of financial capital can also cause the individual means of financing to rise by raising interest rates or by depressing the price of the stock because more is sold than the market wants to absorb. 

Review of Formulas 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 331-332*

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