Chapter 12 Cost of Capital

Chapter 12 Cost of Capital - Chapter 12 Cost of Capital...

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Slides developed by: Pamela L. Hall, Western Washington University Cost of Capital Chapter 12
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2 The Purpose of the Cost of Capital The cost of capital is the average rate paid for the use of capital funds Primarily used in capital budgeting Use as the ‘hurdle rate,’ or benchmark for projects Compare IRR to this rate Discount cash flows at this rate to find NPV If a project cannot earn above this return, it is not worthwhile
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3 The Purpose of the Cost of Capital A firm can only estimate what it will cost to raise future funds, so cost of capital will always be subject to uncertainty Important to estimate this cost as accurately as possible in order to effectively manage the firm The firm’s cost of capital can be viewed as the firm’s required rate of return on projects of average risk
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4 Capital Components Components of a firm’s capital are Debt Borrowed money, either loans or bonds Common equity Ownership interest Preferred stock Cross between debt and equity Capital structure is the mix of the three capital components
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5 Capital Structure Target Capital Structure A mix of components that management considers optimal and strives to maintain Raising Money in the Proportions of the Capital Structure An exact capital structure can’t be maintained constantly Sometimes, if interest rates are low, a firm might issue more debt (to take advantage of the low cost) Increases the weight of debt relative to equity Next time need more capital, issue equity to bring mix back into balance
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6 Capital Structure However, cost of capital calculations assume that capital is raised in the exact proportions of some capital structure Assumption is unrealistic but produces little distortion
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7 Returns on Investments and the Costs of Capital Components Investors provide capital to companies by purchasing their securities The returns to investors represent the costs to the firms in which investments are made Opposite sides of the same coin Since equity is riskier than debt, generally the return on an equity investment is higher than that of debt (or preferred stock), thus the cost to the firm is higher Cost and return are not exactly equal, but are related
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8 The Weighted Average Calculation—The WACC A firm’s WACC is the average of the costs of the separate sources weighted by the proportion of each source used n firm source source source 1 WACC weight cost = =
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9 The Weighted Average Calculation —Example Q: Calculate the WACC for the Zodiac Company given the following information about its capital structure. A: First we need to calculate the capital structure weights based on the value given. For debt this weight is $60,000
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Chapter 12 Cost of Capital - Chapter 12 Cost of Capital...

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