slides19_4up - 1 19 Cost of Capital • The cost of capital...

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Unformatted text preview: 1 19. Cost of Capital • The cost of capital is used to discount expected cash flows in making capital budgeting decisions. • In this chapter, we go into more detail on how to estimate the firm’s cost of capital. • Issues include: – Does it make any difference if the project is financed out of retained earnings , by issuing new equity , or by issuing debt ? – How should we evaluate the cost of capital for projects with risk profiles that differ from that of the overall firm? – What is the effect of operating leverage on a project’s cost of capital? • The key lesson is that the cost of capital depends upon the use of funds, not the source . — 2 It all comes down to fundamentals ... The basic idea is this: • The firm owns some assets . • These assets generate cash flows • The return that investors require to compensate them for holding these assets depends on the – size – timing – riskiness of these cash flows. • The return required by investors determines the cost to the firm of obtaining financing for new investments . • This cost of capital is the appropriate rate to use when discounting cash flows to evaluate potential projects . — 3 Modigliani-Miller In this chapter, we are interested in the overall rate of return the firm must earn on its total assets . Recall that: • The cash flows (and associated risk) can be apportioned to different groups of investors (e.g., shareholders and creditors ) in various ways. • The return that each group will require in compensation for holding these assets depends upon their share of the risk . • But the overall return the firm must earn depends fundamentally on the characteristics of the cash flows , not on how the pie is divided up . Note: In practice, this is not entirely true due to the effects of • taxes • bankruptcy risk • possibly other (minor) factors — 4 Estimating the firm’s cost of capital The return that the firm must earn to compensate investors depends upon the risk profile of its cash flows . • Ideally, one would estimate the appropriate discount rate (required return) directly from these cash flows . • But this is usually hard (impossible!) to do. • Instead, it is common to use the market prices of the firm’s various asset categories (debt, equity, etc) to estimate this rate indirectly . — 5 WACC Estimating the cost of capital: • The firm can be thought of as a portfolio of assets: debt, common stock, preferred stock, ... • (As with any other portfolio) we can estimate the required return for the firm as a whole by taking a weighted average of the component required returns: R A = E A · R E + D A · R D • But, it is often more useful (e.g., when evaluating projects) to look at the after tax cost to the firm , WACC = E A · R E + D A · R D · (1- T ) Notes: • A third term for preferred stock can be added if applicable....
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This note was uploaded on 09/09/2011 for the course BUSINESS 300 taught by Professor N/a during the Spring '09 term at DeVry Chicago.

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slides19_4up - 1 19 Cost of Capital • The cost of capital...

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