Chapter 12 Cost of Capital

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					Chapter 12 Cost of Capital

   I.     Cost of capital

          a. Rate of return on projects needed to maintain market value of stock

          b. Rate of return required to attract capital to the firm

          c. General measure is the average cost of capital

   II.    Four Sources

          a. Debt

          b. Preferred stock

          c. Common stock

          d. Retained earnings

   III.   Cost of debt kd

          a. Rate in interest you have to pay to get people to buy your bonds

          b. Tax treatment

                 i. Since interest payments on debt is tax deductible need to calculate
                    after tax cost of debt.

                 ii. ki = kd (1-T)

   IV.    Cost of preferred stock kp

          a. Preferred stock pays a fixed dividend

          b. Cost is dividend needed to get people to buy the preferred stock

          c. kp = Dp /Np

   V.     Cost of common stock

          a. Cost is dividend required to get people to buy the stock

          b. Ks = Ds /Po or using the growth model ks = Ds /Po + g
VI.     Cost of retained earnings

        a. Cost of retained earnings same as cost of common stock

        b. Investors expect same return on retained earnings as they do on other
           equity capital

        c. Payment comes in the form of capital gain rather than dividend

VII.    Cost of a new issue of common stock

        a. There are costs associated with issuing stock

        b. Capital available to the firm is the amount after expenses

VIII.   Weighted (Average) Cost of Capital

        a. Ka = weighted average cost of all forms of capital

        b. Example: Give out a survey to 10 people asking them to rank satisfaction
           from 1 to 4.

                  Response      Frequency
                  1             1
                  2             3
                  3             4
                  4             2

               i. The average (weighted) response Ra = (1*.1)+(2*.3)+(3*.4)+(4*.2)

               ii. Ra = .1 + .6 + .12 + .8 = 2.7

        c. Formula on page 372

IX.     Marginal cost of capital

        a. Marginal cost of capital is the return needed to attract the next amount of

        b. Marginal cost of capital increases as more capital is used

               i. Each bit of debt or equity increases risk of default

               ii. Need higher returns to attract additional capital
X.   Investment Opportunities Schedule

     a. Ranked list of capital projects for the firm

     b. Internal rate of return declines as go down the list

     c. Raised capital and fund projects as long as IRR > WMCC

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