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% 1
You've reached the end of your free preview.
Want to read all 4 pages?
- Spring '14