# 14 - Cost of Capital Chapter Fourteen Chapter Outline The Cost of Capital Some Preliminaries The Cost of Equity The Costs of Debt and Preferred

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Cost of Capital Chapter Fourteen

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Chapter Outline The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital Flotation Costs and the Weighted Average Cost of Capital
Intuition The required return r must… 1.Compensate our investors( common, preferred, and bonds) for the risks they bear 2.Take into account what fraction of the funding is coming from each type of investor 3.Takes taxes into account ( 29 ( 29 1 0 1 1 1 m m CFFA CFFA NPV CFFA r r = + +⋅⋅⋅+ + +

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Why Cost of Capital Is Important The return (r) earned on assets depends on the risk of those assets Our cost of capital provides us with an indication of how the market views the risk of our assets The cost of capital is our required return for capital budgeting projects
Required Return The required return is based on the risk of the cash flows With the required return we can compute the NPV We need to earn at least the required return to compensate our investors for the financing they have provided

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Initial Assumptions 1. The cash flows of the project are of similar risk to those of the existing firm 2. The project will use a similar mix of financing as the existing firm (
Cost of Equity The return required by common stockholders to invest in our project given the riskiness of project cash flows. Two methods Dividend growth model SML or CAPM ( ch.13)

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The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for R E 1 0 0 0 (1 ) E E D R g P D g R g P = + + = +
Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 1995 1.23 1996 1.30 1997 1.36 1998 1.43 1999 1.50 (1.30 – 1.23) / 1.23 = 5.7

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## This note was uploaded on 06/05/2011 for the course FINA 3000 taught by Professor Laplante during the Spring '08 term at University of Georgia Athens.

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14 - Cost of Capital Chapter Fourteen Chapter Outline The Cost of Capital Some Preliminaries The Cost of Equity The Costs of Debt and Preferred

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