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Unformatted text preview: CHAPTER 12 Cost of Capital CHAPTER ORIENTATION In Chapters 7 and 8 we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects. CHAPTER OUTLINE I. The concept of the cost of capital A. Defining the cost of capital: 1. The rate that must be earned in order to satisfy the required rate of return 2. The rate of return on investments at which the price of a firm's common stock will remain unchanged. B. Investor’s required rate of return is not the same as the firm’s cost of capital due to 1. Taxes: Interest payments on debt are tax deductible to the firm. 2. Flotation costs: Firms incur expenses when issuing securities that reduce the proceeds to the firm. C. Financial Policy 1. Each type of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. 2. Using the cost of a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems. II. Computing the weighted cost of capital. A firm's weighted cost of capital is a function of (l) the individual costs of capital, (2) the capital structure mix, and (3) the level of financing necessary to make the investment. A. Determining individual costs of capital. 50 1. The beforetax cost of debt is found by trialanderror by solving for k d in NP d = t d t n 1 t ) k (1 $I + ∑ = + n d ) k (1 $M + where NP d = the market price of the debt, less flotation costs, $I t = the dollar interest paid to the investor each period, $M = the maturity value of the debt k d = beforetax cost of the debt (beforetax required rate of return on debt) n = the number of periods to maturity. The aftertax cost of debt equals: k d (1  T) where T = corporate tax rate 2. Cost of preferred stock (required rate of return on preferred stock), k ps , equals the dividend yield based upon the net price (market price less flotation costs), or k ps = price net dividend = ps NP D 3. Cost of Common Stock. There are two measurement techniques to obtain the required rate of return on common stock. a. dividendgrowth model b. capital asset pricing model 4. Dividend growth model a. Cost of internally generated common equity, k cs k cs = price market year1 in dividend + dividends in growth annual k cs = cs 1 P D + g 51 b. Cost of new common stock, k ncs k ncs = cs 1 NP D + g where NP cs = the market price of the common stock less flotation costs incurred in issuing new shares....
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This note was uploaded on 02/20/2010 for the course FIN 565 taught by Professor Libnitz during the Spring '10 term at Academy of Design Tampa.
 Spring '10
 LIbnitz
 Finance, Cost Of Capital, Debt, Valuation

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