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To expand operations, firms often require more funds than can be generated from operations. These additional funds require a long-term source of capital. There are two primary means of raising the required additional funds: borrowing the funds (bonds), or selling ownership (stock shares). There is a cost to the firm of raising capital using either method. The firm expects to receive a financial benefit from the assets acquired with the raised capital. To ensure the benefit outweighs the cost of the capital, the firm must determine with some accuracy the cost of the capital and compare it to the benefit to be received. Determining the cost of borrowing is straightforward.
Calculating the cost of selling shares in the firm is more complex.
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