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Chapter 10 The Cost of Capital

Chapter 10 The Cost of Capital - Chapter 10 The Cost of...

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Chapter 10     The Cost of Capital Required Rate of Return(Req’d ROR):  the minimum return an investor requires         to purchase a security or invest in a project. I. Two differences between Req’d ROR and Cost of Capital A. Taxes:  interest expense on borrowed money is tax-deductible.        Ex:  Borrow at 8% and firm’s marginal tax rate is 30%.      Actual Cost of Capital = 8% x (1 - .30) =  5.6% B. Floatation Costs:  transaction costs a firm pays to raise                                 capital by issuing new securities. Ex:  A firm sells new shares of stock for $20.00 per share and floatation       costs are $2.00 per share.  The investor’s Req’d ROR is 7%.        To satisfy the investor’s Req’d ROR, the firm must earn: 7%  x  $20.00  =  $1.40 per share.         But, the firm only has $18.00 to work with, so the cost of capital is          the amount that has to be earned on the $18.00 proceeds:                         $1.40   K E  = ---------------- =  7.1%                   (20.00-2.00) II.    Definitions A.
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