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Chapter 17

Overall approach

The discount rate used in investment appraisal, known as the cost of capital,
represents the company’s costs of long-term finance.

The costs of each source of finance will differ depending on the risk levels taken on
by the investor in that finance.

If an investor takes on higher risk in their investment they will seek
a higher return.

To calculate a cost of capital:

 identify the sources of finance used – look for equity,
preference share and debt sources, bearing in mind that there
may be more than one debt source

 for each type calculate the cost – the cost will relate to the risk
levels taken on by the investor in that finance

If an investor takes on higher risk in an investment they will
seek a higher return, increasing the cost to the company of
getting that finance

 calculate a weighted average of all the costs – the weighting
will be the value (either book or market value) of each finance
source

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