We know that the particular mixture of debt and equity a firm chooses to employ-its capital structure-is a managerial variable. We will take the firm's financial policy as given. In particular, we will assume that the firm has a fixed debt-equity ratio that it maintains. This ratio reflects the firm's target capital structure. How a firm might choose that ratio is the subject of our next chapter. From the preceding discussion, we know that a firm's overall cost of capital will reflect the required return on the firm's assets as a whole. Given that a firm uses both debt and equity capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and those needed to compensate its stockholders. In other words, a firm's cost of capital will reflect both its cost of debt capital and its cost of equity capital. We discuss these costs separately in the sections that follow.
CONCEPT QUESTIONS
a) What is the primary determinant of the cost of capital for an investment?
b) What is the relationship between the required return on an investment and the cost of capital associated with that investment?