Chapter11 - FIN3100: Chapter 11 Cost of Capital Learning...

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FIN3100: Chapter 11 Cost of Capital
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Learning Objectives Know how to determine a firm’s costs of common equity, debt, and preferred stock. Calculate the weights of the components using market values. Know how to determine a firm’s overall cost of capital. Understand how to evaluate a project that is more/less risky than is usual.
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Why is the Cost of Capital Important? We know that the return earned on assets depends on the risk of those assets. The return to an investor is the same as the cost to the company. Knowing our cost of capital allows us to determine our required return for capital budgeting projects. We need to earn at least the required return to compensate our investors for the financing they have provided.
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Sources of Financing
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WACC The weighted average cost of capital (WACC) is estimated by multiplying each component weight by the component cost and summing up the products. The WACC is the minimum acceptable rate of return that the firm should earn on its investments of average risk, in order to be profitable. WACC is the discount rate for computing NPV and the hurdle rate for IRR (IRR > WACC for acceptance of project).
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Capital structure Weights Notation E = market value of equity = # outstanding shares times price per share PS = market value of preferred = # outstanding shares times price per share D = market value of debt = # outstanding bonds times
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Chapter11 - FIN3100: Chapter 11 Cost of Capital Learning...

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