Section outline

  • A company grows by making investments expected to increase revenues and profits. The company acquires the capital or funds necessary to make such investments by borrowing or using funds from owners. The company is producing value today by applying this capital to investments with long-term benefits. But how much value?
    The answer depends not only on the investments’ expected future cash flows but also on the cost of the funds. Borrowing is not costless. Neither is using owners’ funds.
    The cost of this capital is an important ingredient in both investment decision-making by the company’s management and the valuation of the company by investors. If a company invests in projects that produce a return over the cost of capital, the company has created value; in contrast, if the company invests in projects whose returns are less than the cost of capital, the company has destroyed value. Therefore, estimating the cost of capital is a central issue in valuation.