A company grows by making investments that are expected to increase revenues and profits. The company acquires the capital or funds necessary to make such investments by borrowing or using funds from owners. By applying this capital to investments with long-term benefits, the company is producing value today. But, how much value? The answer depends not only on the investments’ expected future cash flows but also on the cost of the funds. Borrowing is not costless. Neither is using owners’ funds.
The cost of this capital is an important ingredient in both investment decision making by the company’s management and the valuation of the company by investors. If a company invests in projects that produce a return in excess of the cost of capital, the company has created value; in contrast, if the company invests in projects whose returns are less than the cost of capital, the company has actually destroyed value. Therefore, the estimation of the cost of capital is a central issue in corporate financial management. For the analyst seeking to evaluate a company’s investment program and its competitive position, an accurate estimate of a company’s cost of capital is important as well.
Cost of capital estimation is a challenging task. As we have already implied, the cost of capital is not observable but, rather, must be estimated. Arriving at a cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project.
This reading is organized as follows: In the next section, we introduce the cost of capital and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital. Section 4 discusses issues an analyst faces in using the cost of capital. A summary concludes the reading.