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CH19sguide - 19 TheCostofCapital forForeignProducts...

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Chapter Objectives 1. To explain how to compute the weighted average cost of capital and its component costs of capital 2. To discuss how corporate and country characteristics influence the cost of capital for foreign projects. 3. To analyze a company's optimum capital structure and identify key factors involved in establishing a company's worldwide capital structure. 4 To describe the relationship between the marginal cost of capital and foreign investment analysis. 5. To compare the cost of capital across major countries. 6. To discuss the capital structure across major countries. Chapter Outline I. The Weighted Average Cost of Capital A. The weighted average cost of capital (WACC) is a weighted average of the components costs: the cost of debt, the cost of preferred stock, and the cost of equity. B. The WACC is normally used as the firm’s cost of capital for the following reasons: The Cost of Capital for Foreign Projects     1 19 The Cost of Capital  for Foreign Products
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i. If a single component cost is used as a criterion for acceptance, projects with a low rate of return may be accepted while projects with a high rate of return may be rejected. ii. If a firm accepts projects that yield more than its WACC, it can increase the market value of its common stock. C. The formula for WACC is: ( 29 ( 29 t e k S B B k S B S k + + + = where k = WACC, k e = cost of equity, k t = after-tax cost of debt, B = market value of the firm’s debt, and S = market value of a firm’s equity. D. Cost of equity i. There is no measurable element for the cost of common equity because dividend declarations are made at the discretion of a firm’s board of directors. ii. The cost of equity for a firm is the minimum rate of return necessary to attract investors to buy or hold a firm’s common stock. 1. This required rate of return is the discount rate that equates the present value of all expected future dividends per share with the current price per share. iii. The formula for cost of equity is g P D k e + = 1 where D 1 = expected dividends per share to be paid at the end of one year, P = current market price per share, and g = annual dividend growth rate. iv. An alternative approach is the capital asset pricing model (CAPM). This can be used when a market is in equilibrium and, if this condition is met, the expected rate of return on an individual security (j) is states as follows: ( 29 j f m f j R R R R β - + = where R j = expected rate of return on security j, R f = riskless rate of interest, R m = expected rate of return on the market portfolio, and j β = systematic risk of security j. 1. This equation is known as the security market line and it consists of the riskless rate of interest (R f ) and a risk premium [(R m -R f ) j β ], for a particular firm J. 2. The term (R m – R f ) is known as the market risk premium.
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