imchap12 - 12-1 1CHAPTER 12 Cost of Capital CHAPTER...

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Unformatted text preview: 12-1 1CHAPTER 12 Cost of Capital CHAPTER ORIENTATION In Chapter 4 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 of the firm's investors. 2. The rate of return on investments at which the price of a firm's common stock will remain unchanged. B. Type of investors and the cost of capital. 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 a single source of capital as the hurdle rate is tempting to management, particularly when an investment is 12-2 2financed entirely by debt. However, doing so is a mistake in logic and can cause problems. II. Factors determining the cost of capital A. General economic conditions. These include the demand for and supply of capital within the economy, and the level of expected inflation. These are reflected in the riskless rate of return. B. Market conditions. The security may not be readily marketable when the investor wants to sell; or even if a continuous demand for the security does exist, the price may vary significantly. C. A firm's operating and financing decisions. Risk also results from the decisions made within the company. This risk is generally divided into two classes: 1. Business risk is the variability in returns on assets and is affected by the company's investment decisions. 2. Financial risk is the increased variability in returns to the common stockholders as a result of using debt and preferred stock. D. Amount of financing required. The last factor determining the corporation's cost of funds is the amount of financing required, where the cost of capital increases as the financing requirements become larger. This increase may be attributable to one of two factors. 1. As increasingly larger security issues are floated in the market, additional flotation costs (costs of issuing the security) and underpricing will affect the percentage cost of the funds to the firm. 2. As management approaches the market for large amounts of capital relative to the firm's size, the investors' required rate of return may rise. Suppliers of capital become hesitant to grant relatively large amounts of funds without evidence of management's capability to absorb this capital into the business. 12-3 3E. In summary. Generally as the level of risk rises a larger risk premium must be earned to satisfy a firm's investors. This, when added to the risk-free rate, equals the firm's cost of capital. 12-4...
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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.

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imchap12 - 12-1 1CHAPTER 12 Cost of Capital CHAPTER...

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