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40 preferred 10 106 common 50 weighted cost 2 3 4 56

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Unformatted text preview: rce of capital (1) Weight (2) Cost (3) Debt .40 Preferred .10 10.6 Common .50 Weighted cost [(2) (3)] (4) 5.6% 13.0 Weighted average cost of capital $600,000 to $1,000,000 Debt .40 Preferred .10 10.6 5.6% Common .50 14.0 Weighted average cost of capital $1,000,000 and above Debt .40 8.4% Preferred .10 10.6 Common .50 14.0 Weighted average cost of capital 2.2% 1.1 6.5 9.8% 2.2% 1.1 7.0 10.3% 3.4% 1.1 7.0 11.5% FIGURE 11.1 WMCC Schedule Weighted marginal cost of capital (WMCC) schedule for Duchess Corporation Weighted Average Cost of Capital (%) CHAPTER 11 The Cost of Capital 487 11.5% 11.5 WMCC 11.0 10.5 10.3% 10.0 9.8% 9.5 0 500 1,000 1,500 Total New Financing ($000) Range of total new financing $0 to $600,000 $600,000 to $1,000,000 $1,000,000 and above WACC 9.8% 10.3 11.5 weighted marginal cost of capital (WMCC), which increases as levels of total new financing increase. Figure 11.1 presents the WMCC schedule. Again, it is clear that the WMCC is an increasing function of the amount of total new financing raised. The Investment Opportunities Schedule (IOS) investment opportunities schedule (IOS) A ranking of investment possibilities from best (highest return) to worst (lowest return). EXAMPLE At any given time, a firm has certain investment opportunities available to it. These opportunities differ with respect to the size of investment, risk, and return.8 The firm’s investment opportunities schedule (IOS) is a ranking of investment possibilities from best (highest return) to worst (lowest return). Generally, the first project selected will have the highest return, the next project the second highest, and so on. The return on investments will decrease as the firm accepts additional projects. Column 1 of Table 11.3 shows Duchess Corporation’s current investment opportunities schedule (IOS) listing the investment possibilities from best (highest return) to worst (lowest return). Column 2 of the table shows the initial investment required by each project. Column 3 shows the cumulative total invested 8. Because the calculated weighted average cost of capital does not apply to risk-changing investments, we assume that all opportunities have equal risk similar to the firm’s risk. 488 PART 4 Long-Term Financial Decisions TABLE 11.3 Investment Opportunities Schedule (IOS) for Duchess Corporation Investment opportunity Internal rate of return (IRR) (1) Initial investment (2) Cumulative investmenta (3) A 15.0% $100,000 $ 100,000 B 14.5 200,000 300,000 C 14.0 400,000 700,000 D 13.0 100,000 800,000 E 12.0 300,000 1,100,000 F 11.0 200,000 1,300,000 G 10.0 100,000 1,400,000 aThe cumulative investment represents the total amount invested in projects with higher returns plus the investment required for the corresponding investment opportunity. IOS and WMCC Schedules Using the IOS and WMCC to select projects for Duchess Corporation Weighted Average Cost of Capital and IRR (%) FIGURE 11.2 15.5 A 15.0 B 14.5 C 14.0 13.5 D 13.0 12.5 E 12.0 11.5% WMCC 11.5 F 11.0 10.3% 10.5 G 9.8% 10.0 IOS 9.5 0 500 1,000 1,100 1,500 X Total New Financing or Investment ($000) funds necessary to finance all projects better than and including the corresponding investment opportunity. Plotting the project returns against the cumulative investment (column 1 against column 3) results in the firm’s investment opportunities schedule (IOS). A graph of the IOS for Duchess Corporation is given in Figure 11.2. CHAPTER 11 FOCUS ON PRACTICE Theory or Practice? Do major U.S. corporations practice what your professors teach? A recent survey of the cost of capital techniques at Fortune 1000 firms showed that financial managers today pay more attention to the cost of capital and its role in capital budgeting and valuation of the firm than they did 15 years ago. A contributing factor is the growing popularity of performance evaluation models that use cost of capital in their formulas, such as economic value added (EVA®, discussed in Chapter 9). The survey, which updated a study conducted in 1982, revealed that companies are becoming more sophisticated in their knowledge and use of financial techniques. Here are the key findings from the 111 respondents, of whom 41 percent were manufacturers, 46 percent suppliers of services, and 13 percent distributors. The Cost of Capital 489 In Practice • Most firms calculate the cost of capital using long-term debt and equity, although some exclude capital leases and preferred stock. • Over 60 percent of firms differentiate project risk on an individual project basis and adjust the discount rate rather than cash flows. • Over 90 percent use a weighted average cost of capital (WACC); about half base the calculation on target weights, another 35 percent on current market value weights. • About half of the respondents recalculate their cost of capital when environmental conditions (shifts in long-term rates) warrant; another 27 percent recompute it annually. • The current capital structure of most respondents is cons...
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