Cost of Capital

A firm’s cost of capital is the net price it must pay for its total mix of capital financing, both debt

and equity, after considering any tax impact and the floatation costs, which constitute all the

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expenses directly related to arranging the financing. This price paid is the cost of capital to the

firm, and is governed, or constrained, primarily by the rate of return required by investors who

are willing to purchase the firm’s securities with the perceived risk associated with them.

The firm’s cost of capital is also the firm’s minimum required rate of return (or hurdle rate) on

any new capital investments. To accept any capital projects with a lower rate of return than the

cost of capital would result in a reduction of shareholder wealth because it would obviously cost

more to finance the capital investment than the return yielded. For most financial decision

making, the relevant cost of capital rate is the “marginal” weighted average cost of capital. This

cost represents the next best available, or marginal, increment of capital that the firm can raise

for future capital expenditures.


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