Cost of Capital

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CHAPTER 11: THE COST OF CAPITAL

LEARNING GOALS:
1. Understand the key assumptions, the basic concept and the specific sources of capital associated with the cost of capital. 2. Determine the cost of long-term debt and the cost of preferred stock. 3. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of common stock. 4. Calculate the weighted average cost of capital (WACC) and discuss alternative weighing schemes. 5. Describe the procedures used to determine break points and the weighted marginal cost of capital (WACC). 6. Explain the weighted marginal cost of capital (WMCC) and its use with the investment opportunities schedule (IOS) to make financing/. Investment decisions.

COST OF CAPITAL- the rate of return that a firm must earn on the projects in which it invests to maintain its market value and attract funds. * It can also be thought of as the rate of return required by the market suppliers of capital to attract their funds to the firm. * It acts as a major link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the market-place. It is, in effect, the “magic number” that is used to decide whether a proposed corporate investment will increase or decrease the firm’s stock price. Clearly, only those investments that are expected to increase stock price (NPV>0, or IRR>cost of capital) would be recommended.

Key Assumptions:
1. Business Risk- the risk to the firm of being unable to cover operating costs-it is assumed to be unchanged. This assumption means that the firm’s acceptance of a given project does not affect its ability to meet operating costs. 2. Financial Risk- the risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred stock dividends)—is assumed to be unchanged. This assumption means that projects are financed in such a way that the firm’s ability to meet required financing costs is unchanged. 3. After-tax costs are considered relevant- the cost of capital is measured on an after-tax basis. This assumption is consistent with the after-tax framework used to make capital budgeting decisions.

* Target Capital Structure- the desired optimal mix of debt and equity financing that most firms attempt to maintain.

To capture the interrelatedness of financing assuming the presence of a target capital structure, we need to look at the overall cost of capital rather than the cost of capital of the specific source of funds used to finance a given expenditure.

Example:
A firm is currently faced with an investment opportunity. Assuming the following:

Best project available today
Cost = $100,000
Life = 20 years
IRR = 7%

Cost of least-cost financing source available
Debt = 6%

Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the opportunity. Imagine after 1 week later a new investment opportunity is available:

Best project available 1 week later
Cost = $100,000
Life = 20 years
IRR = 12%

Cost of least-cost financing source available
Equity = 14%

In this instance, the firm rejects the opportunity, because the 14% financing cost is greater than the 12% expected return.

SPECIFIC SOURCES OF CAPITAL:

1. Long-term debt
2. Preferred stock
3. Common stock
4. Retained earnings

COST OF LONG-TERM DEBT (ri)- is the after-tax cost today of raising long-term funds through borrowing.

NET PROCEEDS- are the funds that are actually received from the sale of a security.

FLOTATION COSTS- the total costs of issuing and selling a security—reduce the net proceeds from the sale.

* They include two components:
a) Underwriting costs- compensation earned by investment bankers for selling the security b) Administrative costs- issuer expenses such as legal, accounting, printing and other expenses....
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