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Chapter10 - Chapter10 TheCostofCapital LearningObjectives ,...

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Chapter 10 The Cost of Capital Learning Objectives After reading this chapter, students should be able to: Explain what is meant by a firm’s weighted average cost of capital. Define and calculate the component costs of debt and preferred stock. Explain why the cost of debt is  tax adjusted and the cost of preferred is not. Explain why retained earnings are not free and use three approaches to estimate the component cost  of retained earnings. Briefly explain the two alternative approaches that can be used to account for flotation costs. Briefly explain why the cost of new common equity is higher than the cost of retained earnings,  calculate the cost of new common equity, and calculate the retained earnings breakpoint—which is the  point where new common equity would have to be issued. Calculate the firm’s composite, or weighted average, cost of capital. Identify some of the factors that affect the WACC—dividing them into factors the firm cannot control  and those they can. Briefly explain how firms should evaluate projects with different risks, and the problems encountered  when divisions within the same firm all use the firm’s composite WACC when considering capital  budgeting projects. List some problems with cost of capital estimates. Chapter 10:  The Cost of Capital Learning Objectives 243
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Lecture Suggestions Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the  weighted  average  cost of capital (WACC),  to develop  a corporate  cost of capital for use in capital  budgeting. We begin by describing the logic of the WACC, and why it should be used in capital budgeting.  We next  explain how to estimate the cost of each component of capital, and how to put the components together to  determine the WACC.  We go on to discuss factors that affect the WACC and how to adjust the cost of  capital for risk.   We conclude the chapter with a discussion on some problems with cost of capital  estimates. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case  solution for Chapter 10, which appears at the end of this chapter solution.  For other suggestions about the  lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) 244 Lecture Suggestions Chapter 10:  The Cost of Capital
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Answers to End-Of-Chapter Questions 10-1 Probable Effect on r d (1 – T)                     r   s                   WACC     a. The corporate tax rate is lowered.
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