The long-term investments we make today will determine the value of our business tomorrow. In order to make long-term investments in new product lines, new equipment and other assets, managers must know the cost of obtaining funds to acquire these assets. The cost associated with different sources of funds is called the cost of capital. Cost of capital represents the rate a business must pay for each source of funds - debt, preferred stock, common stock, and retained earnings.

Since we want to maintain existing market values, cost of capital is the minimum acceptable rate of return for long-term investments. If the business earns more than its cost of capital, the market value of the business will increase. Likewise, if returns on long-term investments are below the cost of capital, market values will decline. Maximizing value for the owners of the business is a fundamental objective within financial management. Therefore, how we manage capital is extremely important to fulfilling the basic objective of increased shareholder value.