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The Value Of A Firm 's Cost Of Capital Essay

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Insert Creative Title Here – don’t forget to change paper name Calculating a firm’s cost of capital is highly important in capital budgeting as capital costs are used to determine investment opportunities, which in turn determines the profitability of the firm. This is true even if a firm knows that a particular project will be financed in a particular way. For example, with debt, the firm must use the concept of Weighted Average Cost of Capital to evaluate all of their capital investment projects. 1 The target capital structure, which determines the cost of capital, must be applied to each investment opportunity because if all the cheap (i.e. debt) capital is used for one project, only the expensive (i.e. equity) capital will be available for future consideration. A later project could be considered unprofitable if evaluated with the cost of equity, but profitable if evaluated with the Weighted Average Cost of Capital (WACC). This can become confusing for the person evaluating the projects, but there is an easier solution. The optimal capital budget results only when each investment opportunity is evaluated with the WACC. Each dollar in the capital budget is considered part debt, part preferred stock and part common equity. Of course, the equity will come from either current retained earnings or the sale of new common stock.
To find the WACC, the cost of each of the capital components mentioned above as debt, preferred stock and common equity are calculated

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