Cost of Capital
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
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