Chapter 11

Chapter 11 - 1 PrinciplesofFinanceFIN3100 Chapter11 The...

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Principles of Finance – FIN 3100 Chapter 11  – The Cost of Capital 1 Patty Robertson
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Agenda Understand the different kinds of financing  available. Learn how to determine a firm’s overall cost of  capital (the discount rate). Explain how the WACC is used in capital  budgeting models. Select optimal project combinations for a firm’s  2
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Cost of Capital Up until now, we have been using the terms  required rate of return  and  discount rate  interchangeably. Both refer to the opportunity cost of using capital  one way as opposed to other options that have  the same risk. They are, in fact, the same thing, but from  different perspectives: 3
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Financial Analysis You are tasked with evaluating the merits of a  proposed investment. Your analysis includes: 1. Determine the relevant cash flows. 2. Discount the cash flows . 3. Recommend the project if the NPV >  0. 4
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Chapter 2 Slide - Cash Flow Identity The  cash flow identity  states that the cash flow on the  left-hand side of the balance sheet is equal to the cash  flow on the right-hand side, such that:     Cash Flow to Creditors + Cash Flow to Owners = Cash Flow From Assets 5
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What Are We Trying To Do? We need to determine the  discount rate  for the  asset investment decision ( Ra )… 6 Assets $1,000 Debt $400 Equity $600 Total Assets $1,000 Balance Sheet Ra
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What Are We Trying To Do? …i t’s the same as its funding costs. 7 Assets $1,000 Debt $400 Equity $600 Total Assets $1,000 Balance Sheet Ra Re Rd
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Financial Analysis Accurate  capital budgeting  requires an  appropriate discount rate, which depends on the  riskiness of the project. The project will only have a positive NPV if  its return exceeds what is offered in the  financial markets for investments with  similar risk. 8
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Cost of Capital In this final chapter, we look at things from the  perspective of the firms that issue securities . In efficient markets, firms raise capital at fair  market values. The return required by an investor in a security  is the same  as the cost of that security to the  firm that issued it. A firm needs to earn at least the required return to  9
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Cost of Capital The cost of capital associated with an investment  depends on the risk of the investment  (the risk of  the cash flows). The cost of capital depends on the use
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Chapter 11 - 1 PrinciplesofFinanceFIN3100 Chapter11 The...

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