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8/6/2019 Cost of Cost
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The Cost of Capital
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The Cost of Capital The Cost of Capital is the rate of return that a
firm must earn on its investment projects to
increase the market value of its commonshares.
Only those investment projects whose expected
returns are greater than or equal to the cost offunds used to acquire the projects would be
recommended.
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Basic Assumptions
The cost of capital is dynamically affected by
many economic and firm specific factors.
Business Risk Financial Risk
The cost of capital is measured on an after-tax basis.
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TheB
asic Concept Firms typically raise money in lumps, the cost of
capital should reflect the interrelatedness of
financing activities.
Most firms maintain a deliberate mix of debt and
equity financing to minimize the cost of capital,
called the Optimal Capital Structure.
The Optimal Capital Structure looks at the overallcost of capital, not just the cost of specific funds.
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Cost of Specific Sources
of Capital
To determine which fixed asset investments
should be selected, the cost of capital must
be known.
Three basic sources of long-term funds are:
Long-term debt,
Preferred equity, and
Common equity.
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Before-Tax Cost of Debt
When net proceeds from a bond equal its parvalue, the before-tax cost will equal the
coupon rate. The Yield to Maturity on a similar-risk bond isalso used.
The before-tax cost of debt can be found by
calculating the Internal Rate of Return (IRR)on the bond cash flows, and is called the costof maturity.
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After-Tax Cost of Debt Because interest on debt is tax deductible, it
reduces the firms taxable income.
Simply state the After-Tax Cost of Debt is:
kdt=k
dv (1-T)
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Cost of Preferred Equity The Cost of Preferred Equity, kp, is the ratio
of the preferred share annual dividend to the
net proceeds from the sale of the preferredshares.
p
p
p
N
Dk !
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Cost of Common Equity There are two forms of common equity
financing:
reinvested profits; and new issues of common shares.
The Cost of Common Equity, ks, is theexpected return investors require to hold the
common shares of the company.
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Finding the Cost with DVM
The constant-growth dividend valuationmodel (DVM) or Gordon Model equation
can be arranged to solve forks.
Since dividends are paid from after-taxincome, no tax adjustment is required.
gP
ks 0
1
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Cost of Reinvested Profits By retaining earnings, the company is using
common shareholders funds.
The Cost of Reinvested Profits, kr, is equalto the cost of common equity, ks, as follows:
kr=ks
It is not necessary to adjust the cost ofreinvested profits for flotation costs,because these costs are not incurred.
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Cost of New Shares Issues The Cost of New Shares Issues, kn, is
determined by calculating the cost of common
shares, net of discounts and associated flotationcosts.
Normally new issues will be discounted to a
price below the current market price 0.
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Weighted Average Cost of
Capital (WACC) The Weighted Average Cost of Capital (WACC), ka,
reflects the expected average future cost of funds.
ka = (wdv kd) + (wp v kp) + (ws v kr or n)where
wd = proportion of log-term debt in capital structure
wp=
proportion of preferred equity in capital structurews = proportion of common equity in capital structure
wd+ wp + ws = 1.0
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Weighting Schemes
Weights can be calculated based on either
Book Value, or
Market Value for costs.
And may use either
Historic, or
Target proportions for weighting.
The preferred weighting scheme is marketvalue with target proportions.
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Marginal Cost and Investment
Decisions
As the volume of financing increases, the
costs of various types of financing will
increase, raising the firms weighted average
cost of capital.
The Marginal Cost of Capital (MCC) is the
firms average cost of capital associated withits next dollar of total new financing.
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Investment Opportunities
Schedule (IOS)
The Investment Opportunities Schedule
(IOS) is a ranking of investment
possibilities from best (highest return) to
worst (lowest return).
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Using MCC and IOS in Decision-Making
When a projects expected return (internal
rate of return) is equal to or greater than the
marginal cost of new financing, the project
should be accepted.
Firms should accept projects up to the point at
which the marginal return on its investmentequals its marginal cost of capital.
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MCC-IOS Schedules