Series 79: 3.5.8. Cost Of Capital

3.5.8. Cost of Capital

A potential investment’s cost of capital is a hurdle rate based on the investment’s total cost to the investor, whether it be the purchase of a security, the acquisition of a company, or the decision to go forward with a particular project, such as a new factory or product line. For example, if the expected return from a proposed acquisition is less than the cost of capital to make the acquisition, it is probably not a good deal for shareholders.

The most common way to calculate cost of capital involves a weighted average of the cost of capital raised through debt financing (or cost of debt), and the cost of capital raised through equity financing (or cost of equity). Breaking cost of capital down by type of financing is necessary because the methods for calculating cost of equity and cost of debt are different. Each requires making a number of assumptions. Calculating the cost of equity usually involves using the capital asset pricing model (CAPM), which we’ll discuss shortly. Calculating the cost of debt starts with the pre-tax cost of debt, which is the