In Chapter 11, we looked at a firm from the outside — the point of view of an investor in the stock. In this chapter, we put on our corporate manager hats to look at the Cost of Capital to the firm.
Different industries require different rates of return on projects, and that return comes down to how expensive capital is for them. The Cost of Capital always devolves down to risk — and money for a risky project will cost more than money for a less risky project. The variability of required return from industry to industry and from firm to firm reflects how the market perceives the risk.
Whether we are the financial officer of a firm, the marketing person or even the human resources manager, we need to understand the cost of capital. Click here to see how Human Resources Management is changing to Human Capital Management, looking at Human Resources in a Financial manner.
As the article says, “Because the workforce accounts for an enormous share of corporate expense – above 40% on average – a technique that HR professionals can use to prove that their function earns its keep in spades is welcomed. It’s one of two big reasons that human capital management consultants and gurus are getting rapt attention in corporate America.” So while you may not yet need finance for your particular business specialty, it’s coming, and most of it is focused on what kind of return are we getting from our investment, whether the investment is in a marketing campaign or hiring people. This is the reason that so many CEOs come from the finance side of the business.
When you finish your study of this chapter, you should know:
The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!
Cost of equity
Cost of Debt
Weighted average cost of capital (WACC)
Pure play approach
Don’t forget! Homework is due by 6:30 PM on class day by e-mail to firstname.lastname@example.org! Don’t suffer a zero by being late.
You will find, as you read this chapter, that the required return on investment, the discount rate and the cost of capital are all pretty much the same number. It is the use of money that determines its cost, not the source, even though we talk about cost of debt and cost of equity.
The Cost of Equity is most commonly determined by looking at either the Dividend Growth model or by looking at the Security Market Line, otherwise known as the Capital Asset Pricing Model.