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Cost of Capital(1)

# Cost of Capital(1) - Cost of Capital Chapter 9 Definition...

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Cost of Capital Chapter 9 Definition of capital: Capital is defined as the long-term funds the firm raises to purchase assets. The emphasis here is on long-term. Short-term borrowing is not capital. Short-term financing is used to manage the firm’s cash position and it has its own analysis. Capital is maid up of long-term borrowing, bonds, preferred stocks, and common stocks. Capital is used to purchase capital assets. Capital assets are long-term assets the firm would use to conduct its business. For an airline company, these assets would be its airplanes. For a manufacturing company, these assets would be the machinery in the factory. We are concerned about the cost of capital because the company’s assets must produce enough return to pay the lenders and the stockholders of the company. The cost of capital is a weighted average of the cost of the debt and equity of the company. Definition of the cost of capital: The rate of return that must be earned on new investments having the same average risk as the firm’s existing assets, in order to provide all investors in the firm with fair market rates of return. Cost of debt: When calculating the cost of debt we have to consider whether it is existing or new debt. The cost of existing debt is the equal to the bond’s yield to maturity. Calculating the yield to maturity was covered in week 6, bond valuation, of this course. When considering the cost of new debt we have to account for the cost of issuing new debt. This is known as floatation cost. This is the commission paid to the investment dealer for helping the company issue and sell the bonds. Floatation costs increase the cost of debt. When calculating the cost of existing debt we consider the cost of debt without floatation. When calculating the cost of new debt we consider the cost of debt with floatation. Floatation costs for bonds may average between 2 to 10%. Some people say it averages about 5%. Without flotation

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Cost of Capital(1) - Cost of Capital Chapter 9 Definition...

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