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Keynesian economists deliver the mantra that debt financed stimulus will lead the world out of this financial
crisis. They should study what happens when overleveraged businesses make debt financed investments with a
payback that is less than the cost of capital. Implications for investors…

Concepts in Cost of Capital

Each business has a cost of capital that is independent of its financial structure. This is based on variables such as:

  • Risk of obsolescence of products
  • Ability to innovate
  • Competition
  • Size
  • Labor flexibility
  • Need to continuously access the financial markets
  • Financial capability of customers
  • Cyclicality of business
  • Financial market factors (liquidity)

All of these factors are processed by the financial markets into a cost of capital at which future cash flow is
discounted to present value to determine the value of the business. The cost of capital is the discounting
mechanism.

The simplest application of the concept is for a business with no debt and a single class of stock. Since capital
is fungible, all equity capital has the same cost.