CH13 Cost of Capital Notes.doc - Chapter 13 Cost of Capital...

Chapter 13 Cost of Capital
Cost of Capital – weighted average of the capital component costs used to raise money to
finance long-term assets.
WACC = Weighted Average Cost of Capital.
The WACC is the overall return a firm must earn on its existing assets to maintain the value
of the stock. Cost of Capital provides the firm with an indication of how the market views the
risk of its assets.
Assets must earn at least the WACC to be profitable.
New projects must have an expected return greater than WACC to be accepted.
 Component Costs –
1. Cost of Common Equity (R
E
)
A. Use Valuation Formula (Dividend Discount Model) (CHAPTER 7)
R
E
= (D
1
/P
o
) + g
(D
1
/P
o
) = dividend yield
g= dividend growth rate = capital gain yield
For a particular firm P
o
= $25 D
1
= 3.375 and g = 2.5%
R
E
= (3.375/25)+0.025 = 16%
B. Use CAPM: R
E
= R
F +
(E(R
M
) – R
F
) β
E
A firm’s common equity has a β
E
= 1, R
F
= 8.5% and E(R
M
) = 16%.
R
E
=
2. Cost of Debt (R
D
(1-T
C
))
A. Use CAPM: R
D
= R
F
+ (E(R
M
) – R
F
) β
D
For a firm β
D
= .644, R
F
= 8.5% and E(R
M
) = 16%
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