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The Cost of Capital

The Cost of Capital. Chapter 10 Besley. The Cost of Capital. Cost of Capital is the minimum rate of return that must be earned from investments to ensure that the firm’s value does not decrease. Basic Definitions.

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The Cost of Capital

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  1. The Cost of Capital Chapter 10 Besley

  2. The Cost of Capital Cost of Capital is the minimum rate of return that must be earned from investments to ensure that the firm’s value does not decrease.

  3. Basic Definitions Cost of capital used in capital budgeting should be calculated as a weighted average of the various types of funds used by the firm, regardless of the specific financing used to fund the project. WACC = Weighted Average Cost of Capital kd = before tax interest cost on firm debt kdT = kd(1-T) = after tax cost of debt kps = cost of preferred stock ks = cost of retained earnings ke = cost of external equity (new stock); ke > ks

  4. Basic Definitions Capital Structure – Combination of different types of capital used by the firm.

  5. Cost of Debt, kdT • The relevant cost of new debt • Taking into account the tax deductibility of interest • Used to calculate the WACC • Value of the firm’s stock depends on after-tax cash flows, which is why we look at kdT • A firm with losses has a tax rate of zero. kdT = bondholders’ required rate of return minus tax savingskdT = kd - (kd x T) = kd(1-T)

  6. Cost of Preferred Stock, kps • Rate of return investors require on the firm’s preferred stock • The preferred dividend divided by the net issuing price kps = Dps/NP = Dps/P0-Flotation Costs • Since there is no tax savings related to preferred stock, no tax-adjustment is made for kps

  7. Cost of Retained Earnings, ks • Rate of return required by stockholders on the firm’s existing common stock.

  8. Cost of Retained Earnings • Rate of return investors require on the firm’s common stock

  9. The Bond-Yield-Plus-Premium Approach • Estimating a risk premium above the bond interest rate • Judgmental estimate for premium • “Ballpark” figure only

  10. The Discounted Cash Flow (DCF) Approach • Price and expected rate of return on a share of common stock depend on the dividends expected on the stock

  11. The Discounted Cash Flow (DCF) Approach

  12. Cost of Newly Issued Common Stock • External equity, ke • based on the cost of retained earnings • adjusted for flotation costs (the expenses of selling new issues)

  13. Weighted Average Cost of Capital, WACC • A weighted average of the component costs of debt, preferred stock, and common equity

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