Cost of Capital New - Finance 453B: Financial Theory and...

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Finance 453B: Financial Theory and Analysis Autumn Quarter, 2009 Professor William Bradford THE COST OF CAPITAL The Cost of Capital for a firm is the rate of return on investments that will allow the firm to pay creditors and stockholders their required rates of return. The Cost of Capital refers to the yield that the firm must pay capital suppliers after tax. I. Example Suppose the firm has a 50% tax rate and has used $2,000 to purchase an asset. What is the Cost of Capital for that asset? The cost of debt is 8% before tax, and thus 4% after tax. Also assume that stockholders want 15% on their investment in the firm, and that the firm has adopted a policy of 40% debt and 60% equity. Prop. of Required Capital Rate of Return Asset $2,000 Debt $ 800 .40 4.0% Equity 1,200 .60 15.0% $2,000 $2,000 Cost of Capital = .40 X 4.0% + .60 X 15.0% = 10.6% If the firm earns 10.6% on its investment, then both stockholders and creditors will be satisfied with the yield on their investment in the firm. How do we know this?
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Cost of Capital New - Finance 453B: Financial Theory and...

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