The Opportunity Cost of Capital
To maximize the market value of the firm, we need to use the proper required rate of return as the discount
rate for NPV analysis
The firm's proper required rate of return can be viewed as its:
•
Opportunity cost of capital (OCC)
What the firm could earn in an alternative investment of similar risk
•
Weighted average cost of capital (WACC)
Aftertax cost of new funds available for investment by the firm

For average risk projects, opportunity cost of capital (OCC), the required rate of return, and
WACC are the same.

Importance of opportunity cost of capital
Gives the minimum acceptable rate of return on new investments with risk levels similar to the
risk level of the company.
As the opportunity cost of capital increases, the firm’s value falls
Discount rate for determining the net present value for projects of average risk
Weighted average of the firm's aftertax costs of
new
financing

The weights used to determine the opportunity cost of capital (or WACC) are the market value weights
and not book value weights. Investors are interested in how much capital they currently have at risk; they
are not interested in how much they had invested when the securities were issued.
Calculating Costs and Financing Proportions:
Cost of Debt
 Underwriting costs, issuing expenses and sales to the public at a discount reduce the net proceeds that the
issuer receives from a debt issue to below the security’s face value.

To calculate the beforetax cost of debt, we solve for the expected yield to maturity
(
29
+

+
=
2
value
face
ue
market val
g
outstandin
periods
ue
market val
value
face
int
erest
coupon
YTM
approx
Interest is a taxdeductible expense, therefore the aftertax cost of debt:
(
29
(
29
n
d
d
n
d
np
R
1
F
R
R
1
1
1
C
B
+
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=
firm
the
cost to
tax

Before
R
bond
for the
maturity
to
periods
of
Number
n
$1,000)
(typically
bond
the
of
alue
maturity v
or
Par
F
period
each
bond
a
on
paid
interest
of
amount
Dollar
C
tax
before

bond
the
from
proceeds
Net
B
d
np
=
=
=
=
=
equity
common
E
stock
pfd
p
debt
d
W
R
W
R
T)W

(1
R
WACC
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=

debt
of
t
tax
fter
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View Full DocumentExample 1
: A $1000 par value bond will sell in the market for $1072 and carries a coupon interest rate of
9%. Issuing costs will be 7.5% of the selling price. The number of years to maturity is 15 and the firm’s tax
rate is 46%. What is the beforetax and aftertax cost of debt?
Example 2:
SMU Corporation has debt outstanding with a par value of $1,000 per bond. The face value of
all of their debt is $150,000,000 and it is due in 15 years. The coupon rate is 9% compounded semi
annually. The bonds are currently priced to yield 10%. New debt will be issued at par and the flotation
costs are 2% of the face value. The corporate income tax rate is 40%. What is the current market value of
the outstanding debt? What would be the aftertax cost to the firm of issuing new debt?
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 Spring '11
 Mishra
 Finance, Cost Of Capital, Market Value, common equity

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