Fundamentals of Financial Management, Third Edition

SUMMARY

The analysis of the cost of capital is of immense significance in many areas of business finance, more particularly for making investment decisions. This is because it acts as a cut-off rate or minimum acceptable rate of return from an investment. This implies that the cost of capital must be lower than the rate of return from an investment, so as to raise the value of the firm.

Since a firm utilizes different forms of capital, it is required to compute weighted average cost of capital. To this end, the cost of different forms of capital is first computed, and then they are combined along with their respective weights. The cost of existing debt is simply the coupon rate adjusted for taxes, while the cost of new debt needs also to be ...