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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