Chapter 08 Financial Management

Chapter 08 Financial Management - Financial Management ADM...

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1 Financial Management ADM 2350 Professor: Dr. William F. Rentz
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2 ADM 2350 Chapter 8 This session discusses the concept of the cost of capital and develops approaches used to measure it Weighted cost of capital Risk vs. required return trade-off Individual components
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3 Cost of Capital Determined in the capital markets Depends on the risk associated with the firm’s activities What the firm must pay for capital
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4 Cost of Capital The return required by investors Minimum rate of return required on new investments Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk
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5 Weighted Cost of Capital: k a Discount rate used when computing the NPV of a project of average risk Hurdle rate used in conjunction with the IRR Based on the after-tax cost of capital
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6 Weighted Cost of Capital: k a Obtained from the weighted costs of the individual components Weights equal to the proportion of each of the components in the target capital structure
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7 Calculating k a ( 29 ( 29 ( 29 p f f i f e f a k P D E P k P D E D k P D E E k + + + + + + + + = ( 29 ( 29 ( 29 p i e a k k k k 1 6 3 1 1 6 3 3 1 6 3 6 + + + + + + + + = Example with $3M in bonds, $6M in equity, and $1M in preferred stock
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8 Required return = r f + Risk premium r f = risk-free rate Real rate of return determined by supply and demand Plus a premium for the effects of inflation
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9 Required return = r f + Risk premium Components of the risk premium Business risk associated with the amount of operating leverage Financial risk associated with the use of financial leverage Marketability risk refers to the ability to quickly buy and sell Interest rate risk arising from changes in interest rates Seniority risk due to the priority of a security’s claim on assets
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10 Risk-Return Trade-Off of Various Sources of Funds r f Risk Required Return % x Common Stock x Low Quality Corp Debt x High Quality P/S x High Quality Corp Debt x L-T Government Debt x S-T Government Debt
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11 Component Costs k i = k d (1 – T ) Interest is tax deductible k p = D p / P net Dividends are NOT!
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12 Component Costs Cost of internal equity capital
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This note was uploaded on 09/13/2011 for the course ADM 2350 taught by Professor Ronda during the Fall '11 term at University of Ottawa.

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Chapter 08 Financial Management - Financial Management ADM...

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