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Ebook Financial management for decision makers (5th edition): Part 2

(BQ) Part 2 book "Financial management for decision makers" has contents: The cost of capital and the capital structure decision, developing a dividend policy, managing working capital, measuring and managing for shareholder value, business mergers and share valuation. | FINM_C08.qxd 10/23/08 9:28 AM Page 307 8 The cost of capital and the capital structure decision INTRODUCTION We have seen that the cost of capital has an important role to play when appraising investment opportunities. In this chapter, we shall consider how the cost of capital can be calculated. Following this, we turn our attention to the factors that should be taken into account when making capital structure decisions and, in particular, the impact of gearing on the risks and returns to ordinary shareholders. We touched on this area in Chapter 3 and will now consider it in more detail. We conclude the chapter by examining the debate concerning whether there is an optimal capital structure for a business. LEARNING OUTCOMES When you have completed this chapter, you should be able to: l Calculate the weighted average cost of capital for a business and assess its usefulness when making investment decisions l Calculate the degree of financial gearing for a business and explain its significance. l Evaluate different capital structure options available to a business. l Explain the key points in the debate over whether a business has an optimal capital structure. FINM_C08.qxd 308 10/23/08 CHAPTER 8 9:28 AM Page 308 THE COST OF CAPITAL AND THE CAPITAL STRUCTURE DECISION Cost of capital ‘ We saw in Chapter 4 that the cost of capital is used as the appropriate discount rate in NPV calculations and as the appropriate ‘hurdle rate’ when assessing IRR calculations. As investment projects are normally financed from long-term capital, the discount rate, or hurdle rate, applied to new investment projects should reflect the expected returns required by investors in long-term capital. From the viewpoint of the business, these returns represent its cost of capital. This is an opportunity cost as it represents the return that investors expect from investments of similar risk. The cost of capital must be calculated with care as failure to do so could be damaging to