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BCOR 2200 Chapter 12

# BCOR 2200 Chapter 12 - Chapter 12 The Cost of Capital 1...

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1 Chapter 12 The Cost of Capital

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2 Chapter Overview Recall a capital budgeting decision looks like this: Invest only if NPV > 0 We know which CFs to use Total CF = OCF – NWC - NCS Now we need to figure out what R to use: This is the required return of the project Pay CF O , Get CF 1 through CF N Recall: If R < IRR, then NPV > 0 R is the return the company’s investors expect to earn Based on the risk of the company’s business consumer products, consumer durables, luxury goods… What the investors earn = the company’s cost ( 29 ( 29 N N 2 2 1 0 R 1 CF R 1 CF R 1 CF CF NPV + + + + + + + = L
3 Chapter Overview So only do a project if the return on the invested capital is more than the cost of capital This is that same as saying the project has a positive NPV But what is the cost of the capital to the company? The cost of capital is what investors demand from the company What do investors demand? It depends on the investor: Some investors buy the company’s STOCK And they earn an expected return (E(R)) on the stock How do we calculate E(R)? Some investors buy the company’s BONDS And they earn a yield to maturity (YTM) on the bond How do we calculate YTM? Some investors buy the company’s PREFERRED STOCK And they earn a yield (R P ) on the preferred stock How do we calculate the return on preferred stock?

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4 Chapter Overview Determine a firm’s cost of capital raised from selling ownership stakes Return paid to stock or equity holders (R E ) Determine a firm’s cost of capital raised from borrowing money Return paid to bond or debt holders (R D ) Determine a firm’s cost of capital raised from selling Preferred Stock Return paid to preferred stock holders (R P ) Determine a firm’s Weighted Average Cost of Capital: Average these costs by their weights Call it the W eighted A verage C ost of C apital WACC = W E R E + W D R D (1 - T) + W P R P (We’ll get to the “(1 – T)” part later)
5 Chapter Outline 1.Discuss why WACC is the appropriate discount rate for projects 2.Calculate WACC: Calculate the Cost of Equity (R E ) Calculate the Cost of Debt (R D ) Calculate the Cost of Preferred Stock (R P ) Calculate the Weights (Capital Structure) WACC Example 3.Discuss alternatives for projects with different risks

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6 Why is the WACC used for Capital Budgeting? In other words: Why is the WACC the denominator for NPV calcs? Simple Capital Budgeting Problem: Consider a 1 year project that costs \$100 and pays \$110 in 1 year If the discounted future CFs of a project is greater than the cost Then the NPV > 0 Accept the project If the discount rate is 5% NPV = -\$100 + \$110/(1.05) = \$4.76 Here’s another way to think about this project: What is the IRR of this project?
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