The International Cost of Capital and Capital Structure

Abstract

A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and debt (borrowed funds). The firm’s cost of retained earnings reflects an opportunity cost representing what the existing shareholders could have earned if they had received the earnings as dividends and invested the funds themselves. The firm’s cost of new equity capital that is obtained by issuing new stock reflects the opportunity cost of what the new shareholders could have earned if they had invested their funds elsewhere. The cost of new equity capital is higher than the cost of retained earnings because it also includes the expenses associated with selling the new stock; that is, the cost of placing the new issue of stock. The firm’s cost of debt is easier to measure because interest expenses are incurred by the firm as a result of borrowing funds.