Cost of Capital Chapter 11
Chapter 11 - Outline <ul><li>Cost of capital </li></ul><ul><li>Cost of Debt </li></ul><ul><li>Cost of Preferred Stock </li...
Cost of Capital <ul><li>The cost of capital represents the overall cost of financing to the firm. </li></ul><ul><li>The co...
Cost of Debt <ul><li>The cost of debt to the firm is the effective yield to maturity (interest rate) paid to the company’s...
Cost of Preferred Stock <ul><li>Preferred Stock: </li></ul><ul><li>Has a fixed dividend (similar to debt) </li></ul><ul><l...
Cost of Common Equity: Retained Earnings <ul><li>Common stock equity is available through retained earnings or by issuing ...
<ul><li>The cost of new common stock is  higher  than the cost of retained earnings because of flotation costs </li></ul><...
Optimal Capital Structure <ul><li>The optimal (best) situation is associated with the minimum overall cost of capital: </l...
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...
Minimum WACC 40% Cost of equity WACC Cost of debt % Debt ratio % Minimum WACC: lowest cost of capital
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 ...
Cost of Capital and Investment Projects: Stable WACC % Amount of Capital WACC A B C D E F G H
Cost of Capital and Investment Projects: Increasing WACC % Amount of Capital WACC A B C D E F G H
End of Chapter
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14065193

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

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