Chpt 13 Cost of Capital - FIN 300 Fundamentals of Finance Cost of Capital Chapter 13 FIN 300 Cost of Capital 1 The Firms Overall Cost Of Capital Firms

Chpt 13 Cost of Capital - FIN 300 Fundamentals of Finance...

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FIN 300 Fundamentals of Finance Cost of Capital Chapter 13 1 FIN 300 - Cost of Capital
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The Firm’s Overall Cost Of Capital Firms do not issue publicly traded shares for individual projects. 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. FIN 300 - Cost of Capital 2
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The Firm’s Overall Cost Of Capital 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. 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. FIN 300 - Cost of Capital 3
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The Firm’s Overall Cost Of Capital THE FINANCE BALANCE SHEET Is based on market values, rather than book values. Total book value of assets reported on a balance sheet does not necessarily reflect total market value of those assets since book values are largely based on historical costs, while total market value of the assets equals the present value of total cash flows that those assets are expected to generate in future. FIN 300 - Cost of Capital 4
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The Firm’s Overall Cost Of Capital THE FINANCE BALANCE SHEET 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. Values of the claims that investors hold must equal the value of the cash flows that they have a right to receive. FIN 300 - Cost of Capital 5
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The Firm’s Overall Cost Of Capital THE FINANCE BALANCE SHEET Total market value of the debt and the equity of a firm equals the present value of the cash flows that the debt holders and the stockholders have the right to receive. 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. FIN 300 - Cost of Capital 6
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Exhibit 13.1: The Finance Balance Sheet FIN 300 - Cost of Capital 7
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The Firm’s Overall Cost Of Capital HOW FIRMS ESTIMATE THEIR COST OF CAPITAL As long as they can estimate the cost of each type of financing by observing that cost in the capital markets, they can compute the cost of capital for the firm by using the following equation: nFirmi i1 12 2n ni=1k= xk = x k+ xk+...+ xk (13.2)FIN 300 - Cost of Capital 8
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The Firm’s Overall Cost Of Capital HOW FIRMS ESTIMATE THEIR COST OF CAPITAL If we divide the costs of capital into debt and equity portions of the firm, then we can use the above to arrive at the weighted average cost of capital (WACC) for the firm: kFirm= xDebtkDebt+ xEquitykEquity FIN 300 - Cost of Capital 9
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The Firm’s Overall Cost Of Capital WEIGHTED AVERAGE COST OF CAPITAL EXAMPLE The total value of a firm is $4,000,000 and it has $300,000 debt. The cost of debt is 6 percent and the cost of equity is 10 percent. What is the
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