Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know

By William G. Droms | Go to book overview

13
Cost of Capital

The capital budgeting and time value of money concepts explored in the two preceding chapters illustrate the key role of the cost of capital in making long-term investment decisions. This chapter will examine the techniques used to measure the cost of capital and explore the uses of the cost of capital in capital budgeting and capital structure management.


COST OF CAPITAL DEFINED

The cost of capital to a firm may be loosely defined as the percentage cost of permanent funds employed in the business -- that is, the percentage cost of the firm's capital structure. The capital structure is the mix of long-term debt and equity employed by the firm for its permanent financing needs. A useful way to visualize the capital structure is to recast the traditional balance sheet format so that a firm is conceived of as having only two categories of assets -- net working capital and fixed assets. Since net working capital is defined as current assets minus current liabilities, the "revised" right-hand side of the balance sheet will represent the firm's capital structure. This conception envisions a firm as having two categories of assets and two categories of financing for these assets -- long-term debt and equity. Exhibit 13.1 illustrates this conception.

The right-hand side of the reconstructed balance sheet in Exhibit 13.1 represents the "mix" of a company's permanent financing. The cost of this capital structure is of critical importance to the firm in managing its capital structure and in making capital budgeting

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