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Cost of Capital

Cost of Capital - Weighted Average Cost of Capital WACC = w...

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Cost of Capital Cost Cost of Capital of Capital r S • common stock r D • retained earnings • preferred stock • debt Risk Capital capital components (1) Debt • r D = r RF + DRP i + LP i + MRP t r D = risk-free rate plus various risk premiums (2) Preferred Stock • r P = D P /P P P P = D P /r P (3) Common Equity • use an equity model to get r S , the cost of retained earnings • add the flotation costs of issuing new common stock • add a “dilution/risk premium” to the cost of retained earnings to get r e , the cost of new CS possibilities: (a) pure dilution (b) a new signal that new debt is "not available" (c) more risk if more debt is simultaneously being issued
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Unformatted text preview: Weighted Average Cost of Capital WACC = w D *r D (1 – T) + w P *r P + w CE *r CE • for common equity, the firm uses all retained earnings first since r S < r e • actual WACC (WACC*) is the overall “hurdle rate”, i.e. the minimum required rate of return ⇒ use the existing WACC for the discount rate for calculating present values for overall, general corporate decisions • for individual projects and decisions, need to account for risk and calculate the project-specific cost of equity and WACC...
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