slides13 - 13. Cost of Capital In previous chapters we have...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: 13. Cost of Capital In previous chapters we have discussed how to estimate re- quired returns for holding a firms debt and equity . In this chapter, we explore the problem of how to estimate the firms overall cost of capital . The cost of capital will be used to discount expected cash flows in making capital budgeting decisions. We shall see that the cost of capital depends upon the use of funds, not the source . We will also learn about making adjustments to the firms overall cost of capital when evaluating particular projects with risk profiles that differ from that of the overall firm. And finally, we briefly discuss floatation costs . Required return Note that there are several ways to think of returns: the required return is the rate investors require as compensation for foregoing the use of their funds and bearing risk the cost of capital is the rate firms must pay to obtain capital for investment. the appropriate discount rate is the rate that should be used when discounting future cash flows to determine NPV. Ignoring taxes , these should all be the same (why?). 2 Executive summary The firm generates some cash flows . The overall rate of return that the firm must earn depends upon the expected size timing risk of these cash flows. The cash flows (and associated risk) can be apportioned to different groups of investors (e.g., shareholders and creditors) in various ways. The return that each group will require in compensation for holding these assets depends upon their share of the risk. But the overall return the firm must earn does not depend upon how the pie is divided up. Note: There are some caveats, which we will discuss in more detail later in the course. 3 Estimating the firms cost of capital The return that the firm must earn to compensate investors de- pends upon the risk profile of its cash flows . It is difficult to estimate the appropriate discount rate di- rectly from these cash flows. But we can use the market prices of the firms various asset categories to estimate this rate indirectly . 4 WACC The firm can be thought of as a portfolio of assets: debt, common stock, and (possibly) preferred stock. (As with any other portfolio) we can estimate the required re- turn for the firm as a whole by taking a weighted average of the component required returns: R A = E A R E + D A R D Notes: A third term for preferred stock can be added if applicable. Use the market (not book) values of debt and equity! 5 Taxes When evaluating projects, it is more useful to look at the after tax cost to the firm (remember that interest payments are tax deductible)....
View Full Document

This note was uploaded on 03/31/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Fall '07 term at Colorado.

Page1 / 39

slides13 - 13. Cost of Capital In previous chapters we have...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online