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The cost of capital

1.1 Calculating returns

The cost of each source of finance can be equated with the return which the
providers of finance (investors) are demanding on their investment.

In a perfect market:

Market value of investment = PV of expected future returns discounted at the
investors required rate of return

i.e. an investor performs an NPV calculation at their own required return rate to see if
an investment produces returns to satisfy their needs. The investor would not pay a
price higher than the PV of future cash flows of the investment as this would produce
a negative NPV. If investors refuse to buy at the high price, the share price will be
forced down. If the share price were lower than the PV of the future cash flows, all
investors would be attracted by the positive NPV and the high demand for the shares
would push the share price up. In a perfect market, these forces of supply and
demand would push the share price to be equal to the PV of the future cash flows
discounted at the investors’ required return.

In other words:

PV of future returns discounted at investors’ required return – MV of investment = 0

And therefore:

Investors’ required rate of return = IRR of investing at current market price and
receiving the future expected returns.

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