sampe: re-write of finance textbook

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Finance

Groppelli and Nikbakht,  3rd Edition

Barron's Business Review Series (1995)

pgs. 157-158

Cost of Capital:  Basic Concepts

      Individuals have to decide where to invest the income they have saved.  The goal, obviously, is to gain the highest return possible.  To determine which assets are profitable and which are not, investors need a point of reference.  This point of reference is known as the required rate of return.

      Given individual preferences and market conditions, investors establish an expected rate of return for each asset they purchase.  Expected returns are the future receipts investors anticipate receiving for taking the risk of making investments.  If the expected return from an asset falls below the required rate of return, the investment will not be made.  If certain assets are expected to return more than the required rate of return, they will be bought.  For example, suppose an investor calculates that the required rate of return on an investment is 10%.  Given the opportunity to buy an asset with an expected return of 9%, the investor will refuse to purchase this asset. Conversely, assets will be purchased if they return 11 %, 12% or more. 

      A manager of a firm, with the responsibility for making investment decisions, uses a similar point of reference. This point of reference, the firm's required rate of return, is called the cost of capital. The firm must earn a minimum rate of return to cover the cost of generating funds to finance investments; otherwise, no one will be willing to buy its bonds, preferred stock, and common stock. The goal of a financial officer is to achieve the highest efficiency and profitability from assets and, at the same time, keep the cost of the funds that the firm generates from various financing sources as low as possible. In other words, the cost of capital is the rate of return (cost) that a firm must pay investors to induce them to risk their funds and purchase the bonds, preferred stock, and common stock issued by the firm.

      Factors that determine the cost of capital include the riskiness of earnings, the proportion of debt exposure in the capital structure, the financial soundness of the firm, and the way investors evaluate the firm 's securities. If expected earnings or cash flow is volatile, debt is high, and the firm lacks a sound financial record, investors will buy its securities only if high returns are paid to compensate them for taking the risk. In contrast, steadily growing earnings, low debt, and a good financial background will enable the firm to issue securities at low cost.  

      Clearly, the cost of capital is one of the major factors used in the determination of the value of the firm. In finance, the cost of capital is the same as the discount rate. High risk means a high cost of capital, while low risk means a low cost of capital. Moreover, a high cost of capital (high discount rate) usually means a low valuation for securities, and a low discount rate means a high value for the securities of a firm. Since the sale of these securities provides firms with funds for investments, the cost of financing increases when the value of securities is low, and it decreases when their value is high. The benchmark for determining whether the returns of a firm's securities are high or low is the cost of capital.

     The cost of capital to a business firm can best be understood through the process of how it arises, or how it is derived, from the behavior of individual investors.  Individuals have to decide where to invest the income they have saved.  Their goal, obviously, is to gain the highest return possible.  To determine what to invest in, they need a point of reference.  This point of reference is known as their required rate of return, which is simply the return that is necessary to them.  

      Compared to the investor's required rate of return, there is also an expected rate of return for any possible investment opportunity.  Given individual preferences and market conditions, investors can establish an expected rate of return for any asset they may consider.  Expected returns are the future receipts investors anticipate receiving for taking the risk of making investments. 

      These two rates of return will interact in the following way:  If the expected return from an asset falls below the required rate of return, the investment will not be made.  If certain assets are expected to return more than the required rate of return, they will be bought.  For example, suppose an investor calculates that the required rate of return on an investment is 10%.  Given the opportunity to buy an asset with an expected return of 9%, the investor will refuse to purchase this asset.  Conversely, assets will be purchased if they return 11%, 12% or more.

      A manager of a firm, with the responsibility for making investment decisions, faces a situation that is created by this individual investor behavior:  The firm's cost of capital comes from the investor's expected rates of return.  It is the rate of return, which is a cost to it, that a firm must pay investors to induce them to risk their funds and purchase the bonds, preferred stock, common stock, and any other financial instruments issued by the firm.

      A firm's cost of capital can also be looked at as its own minimum required rate of return.  The firm must earn a rate of return at least equal to its cost of capital to cover the cost of generating funds to finance investments; otherwise, no one will be willing to invest in it.  The cost of capital is also a minimum target level for the managers to steer by.  The goal of a financial officer is to achieve the highest efficiency and profitability from assets and, at the same time, keep the cost of the funds that the firm generates from various financing sources as low as possible.

      Factors that determine the cost of capital include the riskiness of earnings, the proportion of debt exposure in the capital structure, the financial soundness of the firm, and the way investors evaluate the firm 's securities.  If expected earnings or cash flow is volatile, debt is high, and the firm lacks a sound financial record, investors will buy its securities only if high returns are paid to compensate them for taking the risk. In contrast, steadily growing earnings, low debt, and a good financial background will enable the firm to issue securities at low cost.  

      In addition, a firm's cost of capital is one of the major factors used in the determination of the value of that firm.  In finance, the cost of capital is the same as the discount rate. High risk means a high cost of capital, while low risk means a low cost of capital.  Moreover, a high cost of capital (high discount rate) usually means a low valuation forsecurities, and a low discount rate means a high value for the securities of a firm.  Since the sale of these securities provides firms with funds for investments, the cost of financing increases when the value of securities is low, and itdecreases when their value is high. The benchmark for determining whether the returns of a firm's securities are high or low is the cost of capital.