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Wk10Gitman_Ch11

# Wk10Gitman_Ch11 - Week 10 Semester 1 2009 Cost of Capital...

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Week 10 – Semester 1, 2009 Cost of Capital 7211AFE CORPORATE FINANCE

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NPV The rule for evaluating a new project: Given the required rate of return k, we discount the cash flows and only accept the project if its NPV is positive (reject if negative). If the required return on an investment is 10%, this means that the investment will only have a positive NPV if its return exceeds 10%.
Required rate of return The required rate of return ( k ) is also called the discount rate, or the cost of capital. But what value for k should we use? One possibility is to use the cost of capital of the firm as a whole .

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Cost of Capital The firm is financed by a mixture of equity and debt. So its cost of capital is a mixture of the cost of its equity and the cost of its debt. These costs are determined by the market. But the mixture is determined by company policy, and the firm may have a preferred debt/equity ratio, called the firm’s target capital structure.
Cost of Capital 2 If the project has a similar risk to the firm as a whole, we may use the firm’s cost of capital in the NPV formula. To calculate the firm’s cost of capital, we will need to calculate (a) the cost of its equity and (b) the cost of its debt, and then (c) combine them.

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Topics to Cover Cost of Debt Cost of Preference Shares Cost of Equity Weighted Average Cost of Capital (WACC) Flotation Costs Economic Value Added (EVA)
Cost of Debt Firms also use debt and, to a lesser extent, preference shares to finance their investments. To a large extent determining the costs of debt and preference shares are comparatively easier than the cost of equity. The cost of debt is the return that lenders currently require on the firm’s debt.

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The cost of debt is the interest rate that the firm pays on new borrowing. (Remember what we need is not the coupon rate but the yield to maturity, YTM). - for publicly listed debt, use YTM - if firm has no publicly traded debt, use YTM on similar debt that is traded. Cost of Debt
YTM of Bond or Debenture In general: where C is \$ coupon interest, k d is required market return for similar securities, n is the number of periods left until repayment, and M is face value. Need to solve for k d n n k k k C ) 1 ( M ) 1 ( 1 1 P d d d 0 + + + - =

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Example Gloss Ltd issued a 20-year, 12% bond 10 years ago. The bond (\$1000 face value) is currently priced at \$860, and pays interest annually. What is its cost of debt?
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