The Cost of Capital

This chapter focuses on the role of cost of capital in corporate finance and capital markets. Cost of capital, or discount rate, is meaningless without a future stream of income, or future net cash flow. The cost of capital is a key variable of capital markets. Noteworthy, the market value of any capital goods does not depend on its past cost; it depends on its future income stream. Hence, the capital value of any asset is a forward-looking concept. Risk of a project is defined in terms of uncertainty of its income stream. The most widely used model for cost of capital in a risky environment is the capital asset pricing model. As typically defined in capital theory, cost of capital is a discount rate with time and uncertainty dimensions. It plays a role in the volume of investment of companies, output growth, and employment. The cost of capital has a direct bearing on the allocation of resources, capital budgeting, and composition of a firm's capital. In addition, it is the competitive return available in the market on a comparable investment, with risk being the most important component of comparability.