Chapter12 Ebook - 6273.ch12.p002-027.qxp 12/14/07 9:01 AM...

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The Cost of Capital w Understand the drivers of the firm’s overall cost of capital. w Measure the costs of debt, preferred stock, and common stock. w Compute a firm’s overall, or weighted average, cost of capital. 12 LEARNING OBJECTIVES notation w Apply the weighted average cost of capital to value projects. w Adjust the cost of capital for the risk associated with the project. w Account for the direct costs of raising external capital. D% Fraction of the firm financed with debt Div 1 Dividend due in one year pfd Dividend on preferred stock E% Fraction of the firm financed with equity FCF t Incremental free cash flow in year g Expected growth rate for dividends P% Fraction of the firm financed with preferred stock P E Price of common stock Price of preferred stock r D Required return (cost of capital) for debt Required return (cost of capital) of levered equity Required return (cost of capital) for preferred stock U Required return (cost of capital) of unlevered equity wacc Weighted average cost of capital T c Marginal corporate tax rate Initial levered value V L O 12-2 6273.ch12.p002-027.qxp 12/14/07 9:01 AM Page 12-2
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In Chapter 11, we learned how to determine a firm’s equity cost of capital. In reality, most firms are financed with a combination of equity, preferred stock, and debt. As a result, financial managers must determine their firm’s overall cost of capital based on all sources of financing. This overall cost of capital is a critical input into the capital budgeting process. The Valuation Principle tells us that the value of a project is the present value of its benefits net of the present value of its “Whenever you assess a project, whether it’s a marketing campaign, an operations initiative, or a new market segment, you must evaluate the benefits and costs of doing the project.” INTERVIEW WITH Priscilla Srbu, Financial Analyst As a staff financial analyst in Qualcomm’s Strategic Finance group, Priscilla Srbu is responsible for valuation analysis for mergers and acquisitions, internal business units, and internal strategic initiatives. She received her MBA from Cornell University in 2007 and her BS from New York University in 2000. Qualcomm, a world leader in digital wireless communications technology products and services, uses the weighted average cost of capital (WACC) as one of several tools to value an investment. When Priscilla analyzes a new line of business or an acquisition candidate, she uses the WACC as the discount rate for future cash flows in calculating the net present value of a potential investment. “The WACC represents the minimum rate of return at which an investment or project produces value for investors,” Priscilla explains. “It also serves as a hurdle rate against which Qualcomm assesses return on invested capital and plays a key role in determining economic value added. For example, assume that a project produces a return of 25 percent and a company’s WACC is 15 percent. Every $1 the company invests in this project creates 10 cents of value. If the company’s return is less than the WACC, however, it is destroying economic value,
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Chapter12 Ebook - 6273.ch12.p002-027.qxp 12/14/07 9:01 AM...

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