FAU FIN 3403 Cost of Capital (Student) - The Weighted...

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The Weighted Average Cost of CapitalCost of Capital– the cost that a firm must pay for the capital it uses to finance newinvestments and investment projects.Capital comes from:1)Debt2)Preferred stock3)Retained earnings4)Common stockAlternatively:Cost of Capitalto the firm is the equilibrium rate of return demanded by investors in thecapital markets for securities in that risk class.So, it is the minimum rate of returnrequired on new investments undertaken by the firm.The role of cost of capital in capital budgeting:IfIRRon New Investment>Cost of CapitalThis is apositive NPVprojectValue offirm risesStock Price rises.IfIRRon New Investment<Cost of CapitalThis is anegative NPVprojectValueof firm fallsStock Price falls.Why is the Cost of Capital equal to the return investors require?Because when the investors give the firm their money, they expect to earn a returncommensurate with the risk of that project or firm.Therefore, at a minimum the firmmust earn at least the Expected Return, E(R), that investors require.So the E(R) from theCapital Asset Pricing Model (CAPM) (and similar models) becomes the minimum ratethat the firm must earn to satisfy investors and this rate becomes one component of therelevant discount rate used in capital budgeting decisions.Computing the Cost of Capital for Each ComponentCost of Equity Capital (Common Stock)Recall the CAPM
jRFMRFjBRRRRE)(Where:jRis the return on thethjstock,RFRis the return on the Risk Free asset,MRis the return on the market,jis the measure of systematic risk.

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