Measuring a Company's Cost of Capital

Abstract

THE aim of this paper is to formulate an explicit and appropriate way of defining and measuring a company's of capital. Such a measure is essential to any rational system for making capital-budgeting decisions. Its function is to provide a correct and objective criterion by which management can determine whether it should or should not accept available proposals involving the expenditure of capital. Because of this function, this concept-the of capital-has also been called the required rate of earnings or the cutoff rate for capital expenditures. The determination of a company's capital budget is an intricate process that requires several simultaneous decisions by management: the total extent of capital expenditures; the form these expenditures will take; and the forms of financing to be used in meeting these expenditures. A rational solution to these complex problems involves three steps. 1. Each available expenditure proposal must be measured for the rate of return it promises. When these measured proposals are ranked in descending order of prospective yield, this list provides management with an explicit picture of the company's potential demand for capital funds. 2. Each available source of capital must be measured for its cost to stockholders. Cost in this context refers to the minimum rate of return that is required to justify the active investment of each succeeding increment of these available funds.' When this listing of amounts and expected costs is arrayed in ascending order of cost, it provides management with an explicit picture of the potential supply and of funds available to the company. 3. A comparison of these two schedules provides an explicit and correct solution to the capital-budgeting problem. Successive proposals should be accepted from within the descending array as long as the prospective yield from each is higher than the of obtaining the increment of funds required for its financing. The first proposal for which capital equals or exceeds prospective yield should be rejected, and so should all proposals promising a smaller yield.