Principles of FinancePart 4,Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western5191 Natorp Blvd.Mason, OH 45040,Chapter 12,The Cost of Capital,Cost of Capital,The firms required rate of return The firms average cost of funds, which is the average return required by the firms investors What must be paid to attract funds,The use of debt impacts a firms ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project,The Logic of the Weighted Average Cost of Capital,Basic Definitions,Component Costs of Capital types of capital used by firms to raise money kd = before tax interest cost 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),Basic Definitions,WACC = weighted average cost of capital Capital structure combination of different types of capital used by a firm,After-Tax Cost of Debt,The relevant cost of new debtits yield to maturity (YTM) Taking into account the tax deductibility of interest Used to calculate the WACC,Cost of Preferred Stock,Rate of return investors require on the firms preferred stock the preferred dividend divided by the net issuing price,Cost of Retained Earnings,Rate of return investors require on the firms common stock,Cost of Retained Earnings,Three solutions: CAPM Discounted cash flow (DCF) Bond yield plus risk premium,The CAPM Approach,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,DCF Approach,Internal equity, ks based on the fact that investors demand the firm use funds that are retained to earn an appropriate rate of return,The Bond-Yield-Plus-Premium Approach,Estimate a risk premium above the bond interest rate Judgmental estimate for premium “Ballpark” figure only,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),Optimal capital structure percentage of debt, preferred stock, and common equity that will maximize the price of the firms stock,Target Capital Structure,Weighted Average Cost of Capital,WACC - A weighted average of the component costs of debt, preferred stock, and common equity,Marginal Cost of Capital,MCC the cost of obtaining another dollar of new capital the weighted average cost of the last dollar of new capital raised,MCC Schedule,Marginal cost of capital schedule a graph that relates the firms weighted average of each dollar of capital to the total amount of new capital raised reflects changing costs depending on amounts of capital raised,Weighted Average Cost of Capital (WACC) (%),MCC Schedule,Break Point,BP the dollar value of new capital that can be raised before an increase in the firms weighted average cost of capital occurs,Weighted Average Cost of Capital (WACC) (%),MCC Schedule,MCC Schedule,Schedule and break points depend on capital structure used,Weighted Average Cost of Capital (WACC) (%),MCC Schedule,Combining the MCC and Investment Opportunity Schedules,Use the MCC schedule to find the cost of capital for determining whether a project should be purchased Investment Opportunity Schedule (IOS) graph of the firms investment opportunities ranked in order of the projects rates of return,Combining the MCC and Investment Opportunity Schedules,WACC versus Required Rates of Return,WACC versus Required Rates of Return,Debt (Bonds) YTM = kd = return investors require to purchase the firms bonds = firms before-tax cost of debt kdT = kd(1-T) = firms after-tax cost of debt,Preferred Stock kps = Dps/P0 = return investors require to purchase the firms preferred stock = firms cost of preferred stock excluding flotation costs kps = Dps/NP0 = kps = Dps/P0(1-F) = firms cost of preferred stock considering flotation costs,WACC versus Required Rates of Return,Common Equity (Stock) ks,= return investors require to purchase the firms common stock = cost of retained earnings,= cost of retained new common equity,ke,End of Chapter 12,The Cost of Capital,