Reading: Debt Policy in a Perfect World

The cost of capital is the return the investors expect to earn, on average, on their invested capital. It is the discount rate we use to compute the present values of future cash flow streams. As we have seen in the previous example, different types of capital have different risks. In our specific example, the firm was able to make the contractual interest payments regardless of the future state of the world (recession, normal, boom). The firm's debt was therefore risk free. In contrast, the payments to the shareholders were not risk free. They were affected by business risk (the future state of the world; recession, expected, boom) as well as financing risk (the amount of debt outstanding). Because of this higher risk, shareholders also expect to earn a higher average rate of return than the providers of debt (14% vs. 10% in our example). Consequently, different sources of capital have different costs, and these costs are not independent from each other. 

With this, we are now ready to formalize the discussion of the cost of capital and the relation between leverage and the cost of capital. In what follows, we denote the cost of capital with the letter k. Specifically, we use the following terminology: 

• k_D is the cost of debt. It is the required (expected, average) rate of return on the interest-bearing debt (financial liabilities)
• k_E ist the cost of equity. It is the required (expected, average) rate of return on equity.
• k_A is the overall cost of capital. It is the required (expected, average) rate of return on assets.