Cost of Capital 1. Introduction, Meaning, and Definition Introduction In financial management, no capital comes for free. Whether a company borrows money from a bank or raises it from shareholders, it must pay a "price" for using that money. This "price" is the Cost of Capital . It serves as the benchmark or "hurdle rate" that a company’s projects must exceed to create value for its owners. Meaning Cost of Capital is the minimum rate of return that a firm must earn on its investments so that the market value of its shares does not fall. It represents the opportunity cost of an investment—i.e., the return that investors could have earned by investing their money in a different project of similar risk. Definition According to James C. Van Horne "The cost of capital is a cut-off rate for the allocation of capital to investment projects. It is the rate of return on a project that will leave unchanged the market pri...
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TRADITIONAL APPROACH-Capital Structure
TRADITIONAL APPROACH-Capital Structure Meaning The Traditional Approach to capital structure states that there is an optimum capital structure at which the overall cost of capital (WACC) is minimum and the value of the firm is maximum . According to this approach: A firm can increase its value by using debt in a reasonable proportion along with equity. Debt is cheaper than equity because interest on debt is tax-deductible and lenders take lower risk. However, excessive use of debt increases financial risk and the cost of equity. Therefore, a proper debt–equity mix is required to achieve an optimum capital structure. Assumptions: Cost of debt remains constant up to a certain level. Cost of equity increases with increased financial risk. Moderate use of debt reduces overall cost of capital. Beyond the optimum point, excessive debt increases WACC and reduces firm value. Tips to Solve Tradition...