Lecture 35 - Business Finance (ACC501) Lesson 35 Review of...

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Business Finance (ACC501) Lesson 35 Review of the Previous Lecture Portfolio Risk Systematic vs. Unsystematic Diversification Topics under Discussion Cost of Capital Cost of Equity Cost of Debt Cost of Preferred Stock Capital Structure Weights The Tax Effect Cost of Capital When we say that the required return on an investment is, say, 10% we mean that the investment will have a positive NPV only if its return exceeds 10%. Alternatively, the firm must earn 10% on the investment just to compensate its investors for the use of the capital needed to finance the project. Thus, 10% is the cost of capital associated with the investment. While evaluating a risk-free project, we look at the capital markets and observe the current rate offered by risk-free investments. Use this rate to discount the project’s cash flows So the cost of capital here is the risk-free rate. If the project is risky, then required return is obviously higher In other words, the cost of capital for a risky project is greater than the risk free rate, and the appropriate discount rate would exceed the risk free rate. So we can use the terms required return , appropriate discount rate and cost of capital interchangeably. The cost of the capital associated with an investment depends on the risk of that investment. Thus, it is the use of money , not the source of money that matters. We know that a firm’s overall cost of capital will reflect the required return on the firm’s assets as a whole. Given that a firms uses both debt and equity capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and stockholders. Cost of capital will reflect
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This note was uploaded on 08/04/2011 for the course ACCT 501 taught by Professor Na during the Spring '11 term at Virtual University of Pakistan.

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Lecture 35 - Business Finance (ACC501) Lesson 35 Review of...

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