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PART SIX Cost of Capital and Long-Term Financial Policy

One of the most important concepts we develop is that of the weighted average cost of capital (WACC). This is the cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm. In discussing the WACC, we will recognize the fact that a firm will normally raise capital in a variety of forms and that these different forms of capital may have different costs associated with them.

We also recognize in this chapter that taxes are an important consideration in determining the required return on an investment, because we are always interested in valuing the aftertax cash flows from a project. We will therefore discuss how to incorporate taxes explicitly into our estimates of the cost of capital.

In Chapter 13, we developed the security market line, or SML, and used it to explore the relationship between the expected return on a security and its systematic risk. We concentrated on how the risky returns from buying securities looked from the viewpoint of, for example, a shareholder in the firm. This helped us understand more about the alternatives available to an investor in the capital markets.

In this chapter, we turn things around a bit and look more closely at the other side of the problem, which is how these returns and securities look from the viewpoint of the companies that issue them. The important fact to note is that the return an investor in a security receives is the cost of that security to the company that issued it.

When we say that the required return on an investment is, say, 10 percent, we usually mean that the investment will have a positive NPV only if its return exceeds 10 percent. Another way of interpreting the required return is to observe that the firm must earn 10 percent on the investment just to compensate its investors for the use of the capital needed to finance the project. This is why we could also say that 10 percent is the cost of capital associated with the investment.

To illustrate the point further, imagine that we are evaluating a risk-free project. In this case, how to determine the required return is obvious: we look at the capital markets and observe the current rate offered by risk-free investments, and we use this rate to discount the project's cash flows. Thus, the cost of capital for a risk-free investment is the risk-free rate.

If a project is risky, then, assuming that all the other information is unchanged, the required return is obviously higher. In other words, the cost of capital for this project, if it is risky, is greater than the risk-free rate, and the appropriate discount rate would exceed the risk-free rate.

We will henceforth use the terms required return, appropriate discount rate, and cost of capital more or less interchangeably because, as the discussion in this section suggests, they all mean essentially the same thing. The key fact to grasp is that the cost of capital associated with an investment depends on the risk of that investment. This is one of the most important lessons in corporate finance, so it bears repeating:

The cost of capital depends primarily on the use of the funds, not the source.

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