Southern Homecare Cost of Capital Case 16
Cost of Capital
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What specific items of capital should be included in a corporate cost of capital estimate? Should historical (embedded) or new (marginal) values be used? Why?
Typically, the corporate cost of capital is used to make long-term capital structure and investment (capital budgeting) decisions. Thus, the estimate should include the firm's long-term sources of funds: long-term debt, preferred stock (if used), and common stock (or fund capital [net assets] for not-for-profit organizations). If a business uses short-term interest-bearing debt as part of its permanent capital base, rather than a temporary source of funds to finance seasonal or cyclical working capital needs, then its corporate cost of capital estimate should include one or more short-term debt components. Non-interest-bearing debt, such as accounts payable and accruals, generally is not included in corporate cost of capital estimates because (1) these funds are netted out when determining investment needs (that is, changes in net working capital are included in capital expenditures); and (2) spontaneous liabilities are not a managerial decision variable—in general, firms take as much as they can get.
In most situations, the corporate cost of capital will be used to make decisions today (in reality, the near future) that will affect future cash flows. In other words, capital will be raised in the future to invest in projects