0321286618_11 - Part 4 Long-Term Financial Decisions...

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Part 4 Long-Term Financial Decisions Chapters in this Part Chapter 11 The Cost of Capital Chapter 12 Leverage and Capital Structure Chapter 13 Dividend Policy Integrative Case 4: O’Grady Apparel Company
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Chapter 11 The Cost of Capital Instructor’s Resources Overview This chapter introduces the student to an important financial concept, the cost of capital. The mechanics of computing the sources of capital-debt, preferred stock, common stock, and retained earnings are reviewed. The relationship between the cost of capital and both the firm’s financing activities and capital investment decisions is explored. In the framework of a target capital structure, the weighted average cost of capital is then applied to capital investment decisions. Study Guide Suggested Study Guide examples for classroom presentation:
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26 Part 4 Long-Term Financial Decisions Example Topic 7 Weighted average cost of capital
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Chapter 11 The Cost of Capital 27 8 Marginal cost of capital schedule
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28 Part 4 Long-Term Financial Decisions Suggested Answer to Chapter Opening Critical Thinking Question In addition to acquisitions, what other uses of capital are made by a growing company? The most common needs for capital in a growing corporation are for the acquisition or upgrade of property and equipment, an increase in inventories associated with increased production, an increase in accounts receivable associated with increased sales, and perhaps to pay down debt. Answers to Review Questions 1. The cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital provides a benchmark against which the potential rate of return on an investment is compared. 2. Holding business risk constant assumes that the acceptance of a given project leaves the firm’s ability to meet its operating expenses unchanged. Holding financial risk constant assumes that the acceptance of a given project leaves the firm’s ability to meet its required financing expenses unchanged. By doing this it is possible to more easily calculate the firm’s cost of capital, which is a factor taken into consideration in evaluating new projects. 3. The cost of capital is measured on an after-tax basis in order to be consistent with the capital budgeting framework. The only component of the cost of capital that actually requires a tax adjustment is the cost of debt, since interest on debt is treated as a tax-deductible expenditure. Measuring the cost of debt on an after-tax basis reduces the cost. The use of the weighted average cost of capital is recommended over the cost of the source of funds to be used for the project. The interrelatedness of financing decisions assuming the presence of a target capital structure is reflected in the weighted average cost of capital. 4.
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This note was uploaded on 11/09/2009 for the course FINANCE 330 taught by Professor Seri during the Spring '09 term at Birzeit University.

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0321286618_11 - Part 4 Long-Term Financial Decisions...

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