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Cost of Capital

# Cost of Capital - Cost of Capital One of the key variables...

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Cost of Capital One of the key variables in capital budgeting decisions is the cost of capital. The cost of capital can be thought of as what the firm must pay for capital or the return required by investors in the firm's securities. It can also be thought of as the minimum rate of return required on new investments undertaken by the firm. The cost of capital is determined in the capital markets and depends on the risk associated with the firm's activities. As we did in the capital budgeting lecture, we will go through the theory first, then use an example to apply the theory. The example in this lecture is similar to the one that will be on your exam. I. The weighted average cost of capital (WACC) is the discount rate used when computing the NPV of a project of average risk. Similarly, the weighted cost of capital is the hurdle rate used in conjunction with the internal rate of return. A. The weighted cost of capital is based on the after-tax cost of capital where the cost of the next (marginal) sources of capital are weighted by the proportions of the capital components in the firm's long-range target capital structure. B. The weighted, or overall, cost of capital is obtained from the weighted costs of the individual components. The weights are equal to the proportion of the market value of each of the capital components in the target capital structure. 1. The appropriate component costs to use in determining k are the marginal costs or the costs associated with the next dollar of capital to be raised. These may differ from the historical costs of capital raised in the past. II. The required return, k, on any security may be thought of as consisting of a risk-free rate of return plus a premium for the risk inherent in the security, or Required return = r f + Risk premium. A. The risk-free rate of return (r f ) is usually measured by the rate of return on risk-free securities such as short term Treasury securities. The risk-free rate consists of 2 components: 1. A real risk-free rate of return determined by supply and demand for funds in the overall economy. 2. An inflation premium to compensate for loss in purchasing power. 1

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B. There are five major risk components which determine the risk premium on a security. 1. Business risk arises from the variability of the firm's operating income and is determined by the variability of sales revenues and expenses and by the amount of operating leverage the firm uses. 2. Financial risk arises from the additional variability of the firm's net earnings associated with the use of financial leverage together with the increased risk of bankruptcy associated with the use of debt. 3. Marketability risk refers to the ability to quickly buy and sell the securities. Securities that are widely traded have less marketability risk than those that are less actively traded.
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Cost of Capital - Cost of Capital One of the key variables...

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