Ch 14 - FIN.pdf - LEARNING OBJECTIVES After studying this...

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After studying this chapter, you should understand: LO1 How to determine a firm’s cost of equity capital. LO2 How to determine a firm’s cost of debt. LO3 How to determine a firm’s overall cost of capital. LO4 How to correctly include flotation costs in capital budgeting projects. LO5 Some of the pitfalls associated with a firm’s overall cost of capital and what to do about them. LEARNING OBJECTIVES 14 437 Cost of Capital and Long-Term Financial Policy PA R T 6 COST OF CAPITAL WITH OVER 95,000 EMPLOYEES ON FIVE CONTINENTS, Germany-based BASF is a major international company. The company operates in a variety of industries, including agriculture, oil and gas, chemicals, and plastics. In an attempt to increase value, BASF launched BASF 2015, a comprehensive plan that included all functions within the company and challenged and encouraged all employees to act in an entrepreneurial manner. The major financial component of the strategy was that the company expected to earn its weighted average cost of capital, or WACC, plus a premium. So, what exactly is the WACC? The WACC is the minimum return a company needs to earn to satisfy all of its investors, including stockhold- ers, bondholders, and preferred stockholders. In 2007, for example, BASF pegged its WACC at 9 percent, and it increased this fi gure to 10 percent in 2008. In this chapter, we learn how to compute a fi rm’s cost of capital and fi nd out what it means to the fi rm and its investors. We will also learn when to use the fi rm’s cost of capital, and, perhaps more important, when not to use it. Suppose you have just become the president of a large com- pany, and the first decision you face is whether to go ahead with a plan to renovate the company’s warehouse distribution system. The plan will cost the company $50 million, and it is expected to save $12 million per year after taxes over the next six years. This is a familiar problem in capital budgeting. To address it, you would determine the relevant cash flows, discount them, and, if the net present value is positive, take on the project; if the NPV is negative, you would scrap it. So far, so good; but what should you use as the discount rate? From our discussion of risk and return, you know that the correct discount rate depends on the riskiness of the project to renovate the warehouse distribution system. In particular, the new project will have a positive NPV only if its return exceeds what the financial mar- kets offer on investments of similar risk. We called this minimum required return the cost of capital associated with the project. 1 Thus, to make the right decision as president, you must examine what the capital markets have to offer and use this information to arrive at an estimate of the project’s cost of capital.
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