4 - The cost of capital: Concept and measurement

Abstract

The chapter discusses the concept and measurement of the cost of capital. The chapter includes an overview of the capital asset pricing model (CAPM) and the weighted average cost of capital (WACC) approach. The cost of capital is derived from the basic linear relationship between risk and return. It is an essential concept in management for assessing the cost of commodity and includes the perspectives of both the company and the investor. Globalization is reducing the cost of capital, the general argument being that when barriers to international investment segment a domestic capital market from global capital markets, local investors bear all the risk of the economic activities in their economy. Such investors require a higher risk premium that effectively reduces the value that local investors are willing to place on the stock relative to what a globally diversified investor would pay if given the chance. Besides reducing market risk premiums, gaining access to global markets also reduces the Betas of most companies, particularly companies whose activities are more strongly correlated with their local economies than with the global economy. Economic Value Added (EVA) is becoming a more and more common tool for European executives to align corporate objectives and decision making with shareholders' interests. It measures the spread between return on the capital employed and the cost of capital. The value of economic profit is to remind managers that they have not really made a profit until they have earned an economic return on the capital they use.