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Financial managers perform many tasks, and one of the most important of these tasks is raising capital
to fund the internal investments of the firm. Businesses identify, analyze, and approve investment
opportunities, and financial managers choose the most efficient way to fund these internal
investments.
The decision criteria for efficient or inefficient funding of the firm‟s internal investments are based
on the firm‟s cost of capital. If the firm raises capital in a manner that reduces or minimizes its cost of
capital, then its financial managers have done well and raised capital efficiently. In contrast, if the firm
raises capital in a manner that increases or does not minimize its cost of capital, then its financial
managers have done poorly and not raised capital efficiently. Financial managers, therefore, regularly
calculate and track their firm‟s cost of capital, so they can determine if the firm is being funded in an
efficient manner.
Financial managers also use their firm‟s cost of capital as a critical input in the investment analysis
process. Internal investment opportunities are identified, and the cash outflows and inflows of these
opportunities are estimated. The cost of capital necessary to fund investment opportunities is used as a
hurdle rate to determine whether the project is a good project or a poor project. If the cash inflows
from the project produce a rate of return on the cash outflows greater than the cost of the capital
invested in the project, then the project should be accepted. If the cash inflows from the project instead
produce a rate of return on the cash outflows less than the cost of the capital invested in the project,
then the project should be rejected.
Managing the firm‟s cost of capital requires that financial managers understand risk and return, and
how to choose the right mix of debt finance and equity finance. This chapter works through these
topics, using both financial theory and practice, so you will understand the factors that determine the
cost of capital and the capital structure of the firm. Financial managers also need to understand how
the firm‟s bonds and stocks are valued using discounted cash flow (DCF) methods, and the last
sections of this chapter discuss and illustrate this process.
Risk and Return
The relationship between risk and return is one of the fundamental relationships in finance, because
investors are risk averse, meaning they prefer less risk to greater risk. It is not true that investors are
unwilling to invest in risky ventures or projects, but it is true that to entice investors to place their
capital in riskier ventures or projects, they must expect to earn a higher rate of return. If you offer an
investor two potential investments, one of lower risk and one of higher risk, and both projects have the
same expected return, a rational investor will always choose the lower-risk investment. For investors
to instead choose the higher-risk alternative, it must have a higher expected return. This higher
expected return must be high enough, in fact, to entice the investor to select the higher-risk alternative.
The relationship between risk and return is a positive one, as shown in Exhibit 5.1.
Exhibit 5.1 The relationship between risk and return.