Overall cost of capital of the firm

A company can be viewed as a collection of projects. As a result, the use of an overall cost of capital as the acceptance criterion (hurdle rate) for investment decisions is appropriate only under certain circumstances. These circumstances are that the current projects of the firm are of similar risk and that investment proposals under consideration are of the same character.

If investment proposals vary widely with respect to risk, the required rate of return for the company as a whole is not appropriate as the sole acceptance criterion. The advantage of using the firm’s overall required rate of return is, of course, its simplicity. Once it is computed, projects can be evaluated a single rate that does not change unless underlying business and financial market conditions change. Using a single hurdle rate avoids the problem of computing individual required rates of return for each investment proposal. It is important to note, however, that if the firm’s overall required rate of return is used as an acceptance criterion, projects should generally correspond to the foregoing conditions. Otherwise, one should determine an individual acceptance criterion for each project.

The overall cost of capital of a firm is a proportionate average of the costs of the various components of the firm’s financing. The cost of equity capital is the most difficult to measure, and it will occupy most of our attention. We also consider the components costs of debt and preferred stock. We will rely on return (yield) calculations to determine cost figures because “cost� and “return� are essentially two sides of the same coin. Our concern throughout will be with the marginal cost of a specific source of financing. The use of marginal costs follows from the fact that we use the cost of capital to decide whether to invest in new projects. Past costs of financing have no bearing on this decision. All costs will be expressed on an after-tax basis, to conform to the expression of investment project cash flows on an after-tax basis . Once we have examined the explicit costs of the various sources of financing, we will assign weights to each source. Finally, we will compute a weighted average of the component costs of financing to obtain an overall cost of capital to the firm.