cH11 - CHAPTER 11 The Cost of Capital Orientation In...

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CHAPTER 11 The Cost of Capital Orientation : In Chapters 7 and 8, we considered the valuation of debt and equity securities. 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 which is an average of the required rates of return of the creditor who loan money to the firm and the stockholders who own the firm. 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 firm’s investors. 2. The rate of return on investments at which the price of a firm’s 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 firm’s total financing provided by each source. 2. Using the cost of a single source of capital as the hurdle rate for a new investment is often tempting to management where all the financing for the investment comes from that source (e.g., the retention of earnings or borrowing). This is a mistake and can lead to serious errors in the firm’s investment decisions. For example, in periods when the firm is borrowing funds to finance 166
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projects the cost of debt becomes the hurdle rate whereas in periods when the firm is issuing equity they use the much higher cost of equity. Consequently, the hurdle rate varies with the source of finance the firm uses and ignores the fact that the firm is actually balancing its debt and equity offerings to maintain a stable capital structure. 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 . Not all firms can sell their debt and/or equity securities when they might want to do it. The market for equity offerings, especially for firms that have never issued equity (i.e., IPOs) is only open to new firms under very optimistic market periods. Thus, general market conditions can have an important impact on a firm’s ability to raise funds at various times. C. A firm’s operating and financing decisions . A firm’s choice of how to finance its assets and when to raise new capital is influenced by the underlying risk that investors see in the firm. In large part this risk results from the decisions made within the company and can be divided into two classes: 1. Business risk is the variability in returns on assets and is affected by the company’s investment decisions.
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