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Lecture 12 - Lecture12 Inthischapter,,,and Thefirm'...

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Lecture 12 In this chapter, we discuss the concept of cost of capital, how the average cost of capital is determined, and  how the cost of capital is used in financial decision making.   The firm's cost of capital is very important because it represents the minimum rate of return that must be  earned from investments.  For this reason, the cost of capital is also known as hurdle rate.  The cost of  capital is, thus, the firm's required rate of return.   Required Return vs. Cost of Capital Required rate of return on an investment is 10%   This means that the investment will have a positive  NPV only if its return exceeds 10%.     We can also interpret this information as the firm must earn 10% on the investment just to compensate for  the use of the capital needed to finance the project.   This is cost of capital view. The important fact to note is that the return an investor in a security receives is the cost of that security to  the company that issued it.  This means we can use the security valuation models from earlier chapters to evaluate the firm's cost of  capital. Components of the Cost of Capital The costs of capital for various capital sources are important for management to decide its  optimal capital  structure .  The optimal capital structure is a combination of debt and equity financing that minimizes the  average cost of capital.  Cost of Debt The cost of debt is the  after-tax cost of debt  because the interest expense on debt if tax deductible.  Therefore, the cost debt is shown as: ) 1 ( T k k d dT - = Note that the cost of debt is the interest rate on  new  debt, not that on already outstanding debt; in other  words, we are interested in the  marginal  cost of debt.  The rate at which the firm has borrowed in the past  is a "sunk cost," and it is irrelevant for cost of capital purposes.
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