Craig A. Stephenson
Financial managers perform many tasks, and one of the most important of these tasks is raising capital to fund the internal investments of the firm. Businesses identify, analyze, and approve investment opportunities, and financial managers choose the most efficient way to fund these internal investments.
The decision criteria for efficient or inefficient funding of the firm’s internal investments are based on the firm’s cost of capital. If the firm raises capital in a manner that reduces or minimizes its cost of capital, then its financial managers have done well and raised capital efficiently. In contrast, if the firm raises capital in a manner that increases or does not minimize its cost of capital, then its financial managers have done poorly and not raised capital efficiently. Financial managers, therefore, regularly calculate and track their firm’s cost of capital, so they can determine if the firm is being funded in an efficient manner.
Financial managers also use their firm’s cost of capital as a critical input in the investment analysis process. Internal investment opportunities are identified, and the cash outflows and inflows of these opportunities are estimated. The cost of capital necessary to fund investment opportunities is used as a hurdle rate to determine whether the project is a good project or a poor project. If the cash inflows from the project produce a rate of return on the cash outflows greater than the cost of ...