# Is Rate of Capital Cost Equal to Return on Capital Employed - PowerPoint

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```					Chapter 13

Cost of Capital
Cost of Capital Defined
• Percentage cost of permanent funds
employed in the business = the
percentage cost of a firm’s capital
structure
• Capital structure = mix of long-term debt
and equity employed for permanent
financing needs
• Exhibit 13.1 shows restructured balance
sheet conception of permanent financing
Average Cost of Capital

• Average cost of capital (ACC): weighted
average after-tax cost of new capital
raised during a year; primarily of interest
for capital structure management
Marginal Cost of Capital
• Marginal cost of capital (MCC): weighted
average after-tax cost of each additional
dollar of new capital raised during a year;
it is primarily of interest for capital
budgeting decisions
• Exhibit 13.2 illustrates the relationship of
MCC to ACC
Marginal Cost and Capital
Budgeting
• Marginal cost of capital should be used as
discount rate for capital budgeting process
• Maximize value of firm by accepting all
projects with an internal rate of return
greater than or equal to marginal cost of
capital
• Optimal-size capital budget is at point of
intersection of MCC and IRR
Cost of Debt
• After tax cost of debt:
Kd = [i/P](1 – T)

• After-tax cost of new debt including
flotation costs:
Kd = [i/P(1 – F)](1 – T)
Cost of Preferred Stock

• Kp = D/P
Cost of Equity

• Ke = D/P + g
Average Cost of Capital

• ACC = (W1)(Kd) + (W2)(Kp) + (W3)(Ke)

• Where
– W1 = % debt
– W2 = % preferred stock
– W3 = % common stock
The Capital Asset Pricing Model
• CAPM is an alternate measure of the cost of
equity capital and is a supplement to
conventional means of measuring Ke.
• Stockholders’ required rate of return on equity
capital is a function of the risk-free rate of return,
the rate of return earned on stocks in general,
and the riskiness of the particular stock.
• Beta measures risk; beta = volatility of stock
relative to market
• CAPM equation: Ke = Rf + (Rm – Rf)B
Capital Structure Management
• Objective of capital structure management is to
find optimal combination of debt and equity that
minimizes the ACC
Since Ke is greater than Kd, mix less expensive
debt with equity to reduce ACC
• As leverage increases, both Ke and Kd increase,
therefore, ACC at first decreases, then increases
with increases in leverage
• Optimal capital structure is in the leverage
position where combined cost of debt and equity
is minimized

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