Ch12 - 12.1 Chapter 12 Cost of Capital 12.2 Issues in...

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Unformatted text preview: 12.1 Chapter 12 Cost of Capital 12.2 Issues in Chapter 12 What is cost of capital? Why is cost of capital important? Know how to determine a firms cost of equity Common stock Preferred stock Know how to determine a firms cost of debt Know how to determine a firms overall cost of capital, or weighted average of cost of capital (WACC) 12.3 Cost of Capital: Georgia Pacific Co. On a market-value basis, our debt-to-capital ratio was 47 percent. By employing this capital structure, we believe that our weighted average cost of capital is nearly optimized at approximately 10 percent .. from Annual Report 12.4 The Cost of Capital: What is it? Simply speaking, it refers to the opportunity cost that a firm incurs in raising capital to finance new projects. Ways to finance new project GE issued 6% 20-year bonds and borrowed capital from JP Morgan to invest on new technology for its electronic division. eBay paid 0.39 share to acquire each of the approximately 68 million fully diluted shares of PayPal. Based on eBay's closing price Thursday of $51.90 in 4 p.m. on the Nasdaq Stock Market trading, the deal was valued at $1.4 billion. (from WSJ, October 14, 2002) 12.5 What types of long-term capital do firms use? Debt Long-term debt (e.g., bond) Equity Preferred stock Common stock Note: Accounting identity: Assets = Liabilities + Equity 12.6 The Cost of Capital What the firm must pay for capital in the capital markets More specifically, minimum rate of return required on new investments Depends on the risk associated with the firms activities Equal to the equilibrium rate of return demanded by investors in the capital markets for securities of that degree of risk 12.7 Why Cost of Capital is Important We know that the return earned on assets depends on the risk of those assets (risk and return trade-off) Our cost of capital provides us with an indication of how the market views the risk of our assets WACC 12.8 Why Cost of Capital is Important Knowing our cost of capital can also help us determine our discount rate for capital budgeting projects The firm uses it to discount future cash flows from investment to be made by the firm. That is, a rate in computing NPV. We need to earn at least the cost of capital to compensate our investors for the financing they have provided 12.9 For example, suppose a firm considers an investment proposal that requires an initial investment of $1 million. The investment will generate $400,000 per year for next three years....
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This note was uploaded on 02/28/2012 for the course FIN 3313 taught by Professor Yi during the Spring '12 term at Texas State.

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Ch12 - 12.1 Chapter 12 Cost of Capital 12.2 Issues in...

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