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PK13 - Chapter 13 The Cost of Capital Learning Objectives 1...

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Chapter 13 The Cost of Capital Learning Objectives 1. Explain what the weighted average cost of capital for a firm is and why it is often used as a discount rate to evaluate projects. 2. Calculate the cost of debt for a firm. 3. Calculate the cost of common stock and the cost of preferred stock for a firm. 4. Calculate the weighted average cost of capital for a firm, explain the limitations of using a firm’s weighted average cost of capital as the discount rate when evaluating a project, and discuss the alternatives that are available. I. Chapter Outline 13.1 The Firm’s Overall Cost of Capital Since unique risk can be eliminated by holding a diversified portfolio, systematic risk is the only risk that investors require compensation for bearing. We concluded in Chapter 7 that we could rely on the CAPM to arrive at the expected rate of return for a particular investment. In this chapter, we address the practical concerns that can make that concept difficult to implement. Firms do not issue publicly traded shares for individual projects.
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As a result, firms have no way to directly estimate the discount rate that reflects the risk of the incremental cash flows from a particular project. Financial managers deal with this problem by estimating the cost of capital for the firm as a whole and then requiring analysts within the firm to use this cost of capital to discount the cash flows for all projects. o A problem with this approach is that it ignores the fact that a firm is really a collection of projects with varying levels of risk. A. The Finance Balance Sheet The finance balance sheet is based on market values rather than book values. The total book value of the assets reported on an accounting balance sheet does not necessarily reflect the total market value of those assets since the book value is largely based on historical costs, while the total market value of the assets equals the present value of the total cash flows that those assets are expected to generate in the future. The left-hand side of the accounting balance sheet reports the book values of a firm’s assets, while the right-hand side reports how those assets were financed. The value of the claims that investors hold must equal the value of the cash flows that they have a right to receive. This is because the total market value of the debt and the equity at a firm equals the present value of the cash flows that the debt holders and the stockholders have the right to receive.
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o The people who have lent money to a firm and the people who have purchased the firm’s stock have the right to receive all of the cash flows that the firm is expected to generate in the future. MV of assets = MV of liabilities + MV of equity B. How Firms Estimate Their Cost of Capital If analysts at a firm could estimate the betas for each of the firm’s individual projects, they could estimate the beta for the entire firm as a weighted average of the betas for the individual projects.
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