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14065193
14065193
14065193
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14065193
14065193
14065193
14065193
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14065193
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14065193
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14065193

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  • 1. Cost of Capital Chapter 11
  • 2. Chapter 11 - Outline
    • Cost of capital
    • Cost of Debt
    • Cost of Preferred Stock
    • Cost of Common Equity:
    • Retained Earnings
    • New Common Stocks
    • Optimum Capital Structure
  • 3. Cost of Capital
    • The cost of capital represents the overall cost of financing to the firm.
    • The cost of capital is normally the relevant discount rate to use in analyzing an investment.
    • The overall cost of capital is weighted average of the various sources, including debt, preferred stock, and common equity
    • WACC = Weighted Average Cost of Capital
    • WACC = After-tax cost × weights
  • 4. Cost of Debt
    • The cost of debt to the firm is the effective yield to maturity (interest rate) paid to the company’s bondholders
    • Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity
    • - After-tax cost of debt= yield × (1- tax rate)
  • 5. Cost of Preferred Stock
    • Preferred Stock:
    • Has a fixed dividend (similar to debt)
    • Has no maturity date
    • Dividends are not tax deductible to the firm and are expected to be perpetual or infinite
    Cost of Preferred Stock Dividend Price – Flotation Cost =
  • 6. Cost of Common Equity: Retained Earnings
    • Common stock equity is available through retained earnings or by issuing new common stock.
    • Common Equity = R.E + New Common Equity
    • The Cost of common equity in the form of retained earnings is equal to the required rate of return on the firm’s common stock (this is the opportunity cost).
  • 7.
    • The cost of new common stock is higher than the cost of retained earnings because of flotation costs
    • Flotation costs: are selling and administrative costs (such as sales commissions) for the new securities
    Cost of Common Equity: New Common Stock
  • 8. Optimal Capital Structure
    • The optimal (best) situation is associated with the minimum overall cost of capital:
    • Optimal capital structure means the lowest WACC.
    • Usually occurs with 30-50% debt in the firm’s capital structure.
    • WACC is also referred to as the required rate of return or discount rate.
  • 9. Example: Cost of Capital 10.41% K a WACC 7.2% 60% 12% K e Equity (R.E) 1.09% 10% 10.94% K P Preferred Stock 2.12% 30% 7.05% K d Debt Weighted cost Weights Cost (After tax) (3) (2) (1)
  • 10. Minimum WACC 40% Cost of equity WACC Cost of debt % Debt ratio % Minimum WACC: lowest cost of capital
  • 11. Example: Projects and Rates of Return $ 95 Total 10 7% H 15 8.6% G 20 9.5% F 11 10.65% E 20 11.8% D 4 13.5% C 5 14% B $10 16% A Cost (Millions) Expected Return Projects
  • 12. Cost of Capital and Investment Projects: Stable WACC % Amount of Capital WACC A B C D E F G H
  • 13. Cost of Capital and Investment Projects: Increasing WACC % Amount of Capital WACC A B C D E F G H
  • 14. End of Chapter

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