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Unformatted text preview: CHAPTER 11 Cost of Capital CHAPTER ORIENTATION In Chapters 7 and 8, we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects. CHAPTER OUTLINE I. The concept of the cost of capital A. Defining the cost of capital: 1. The rate that must be earned in order to satisfy the required rate of return of the firms investors. 2. The rate of return on investments at which the price of a firms common stock will remain unchanged. B. Type of investors and the cost of capital. 1. Each source of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source. 2. Using the cost of a single source of capital as the hurdle rate is tempting to management. For example, this is particularly true when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems. II. Factors determining the cost of capital A. General economic conditions. These include the demand for and supply of capital within the economy and the level of expected inflation. These are reflected in the riskless rate of return. B. Market conditions. The security may not be readily marketable when the investor wants to sell; or even if a continuous demand for the security does exist, the price may vary significantly. 98 C. A firms operating and financing decisions. Risk also results from the decisions made within the company. This risk is generally divided into two classes: 1. Business risk is the variability in returns on assets and is affected by the companys investment decisions. 2. Financial risk is the increased variability in returns to the common stockholders as a result of using debt and preferred stock. D. In summary, as the level of risk rises, a larger risk premium must be earned to satisfy a firms investors. III. Computing the weighted cost of capital. A firms weighted cost of capital is a function of (l) the individual costs of capital and (2) the capital structure mix. A. Determining individual costs of capital. 1. The before-tax cost of debt is found by solving for k d in NP d = = + n 1 t t d t ) k (1 $I + n d ) k (1 $M + where NP d = the market price of the debt, less flotation costs, $I t = the annual dollar interest paid to the investor each year, $M = the maturity value of the debt, k d = before-tax cost of the debt (before-tax required rate of return on debt) n = the number of years to maturity....
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