THE COST OF EQUITY AND CAPITAL

Firms raise money from both equity investors and lenders to fund investments. Both groups of investors make their investments expecting to make a return. Chapter 4 argued that the expected return for equity investors would include a premium for the equity risk in the investment. We label this expected return the cost of equity. Similarly, the expected return that lenders hope to make on their investments includes a premium for default risk, and we call that expected return the cost of debt. If we consider all of the financing that the firm takes on, the composite cost of financing will be a weighted average of the costs of equity and debt, and this weighted cost is the cost of capital.

The chapter begins by estimating the equity risk in a firm and using the equity risk to estimate the cost of equity, and follows up by measuring the default risk to estimate a cost of debt. It concludes by determining the weights we should attach to each of these costs to arrive at a cost of capital.