Cost of Capital Approach

In chapters 3 and 4, we estimated the minimum acceptable hurdle rates for equity investors (the cost of equity), and for all investors in the firm - (the cost of capital). We defined the cost of capital to be the weighted average of the costs of the different components of financing — including debt, equity and hybrid securities — used by a firm to fund its financial requirements. By altering the weights of the different components, firms might be able to change their cost of capital5. In the cost of capital approach, we estimate the costs of debt and equity at different debt ratios, use these costs to compute the costs of capital, and look for the mix of debt and equity that yields the lowest cost of capital for the firm. At this cost of capital, we will argue that firm value is maximized.6.

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