(BQ) Part 2 book "Financial management for decision makers" has contents: The cost of capital and the capital structure decision, making distributions to shareholders, managing working capital, measuring and managing for shareholder value, business mergers and share valuation. | Chapter 8 THE COST OF CAPITAL AND THE CAPITAL STRUCTURE DECISION INTRODUCTION We saw in Chapter 4 that the cost of capital has a vital role to play when using the NPV and IRR methods of investment appraisal. In this chapter, we examine how the cost of capital may be calculated. We first consider how to calculate the cost of each element of long-term capital and then how these costs can be combined so as to derive an overall cost of capital. We shall also take a look at the factors to be taken into account when making capital structure decisions: in particular, the impact of gearing on the risks and returns to ordinary shareholders. We touched upon this area in Chapter 3 but now consider it in more detail. We end the chapter by considering whether there is an optimal capital structure for a business. This is an important topic, which has been the subject of much debate. Learning outcomes When you have completed this chapter, you should be able to: ■ ■ Calculate the degree of financial gearing for a business and explain its significance. ■ Evaluate different capital structure options available to a business. ■ 315 Calculate the weighted average cost of capital for a business and assess its usefulness when making investment decisions. Discuss the key points in the debate over whether a business has an optimal capital structure. 6/5/14 3:53 PM COST OF CAPITAL We saw in Chapter 4 that the cost of capital is used as the discount rate in NPV calculations and as the ‘hurdle rate’ when assessing IRR calculations. As investment projects are usually financed from long-term capital, the discount rate (or hurdle rate) applied to new projects should reflect the required returns from investors in long-term capital. From the business’s viewpoint, these returns represent its cost of capital. It represents an opportunity cost as it will reflect the returns that investors require from investments .
