Contemporary Financial Management
Chapter 8:
The Cost of Capital
Docsity.com
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Guidelines and tips
Prepare for your exams
Study with the several resources on Docsity
Earn points to download
Earn points by helping other students or get them with a premium plan
Capital Structure - E-Commerce - Lecture Slides, Slides of Fundamentals of E-Commerce
Students of Communication, study E-Commerce as an auxiliary subject. these are the key points discussed in these Lecture Slides of E-Commerce :Capital Structure, Weighted Average, Cost, Return Trade, Capital Markets, Risk Associated, Firm, New Securities, Shareholder Wealth, Destroy
Typology: Slides
2012/2013
1 / 11
This page cannot be seen from the preview
Don't miss anything!
Related documents
Partial preview of the text
Download Capital Structure - E-Commerce - Lecture Slides and more Slides Fundamentals of E-Commerce in PDF only on Docsity!
Contemporary Financial Management
Chapter 8:The Cost of Capital
Introduction •^
This chapter discusses:^ •
The cost of capital
- What is it• How is it measured• What is the Weighted Average Cost of Capital
(WACC)
-^
Risk vs. required return trade-off
Concept of Capital Structure •^
A firm’s capital structure consists of the mix ofdebt and equity securities that have been issuedto finance the firm’s activities.
-^
Forms of financing include:^ •
Common stock • Preferred stock • Bonds (secured debt) • Debentures (Unsecured debt)
-^
Each different type of security has different riskcharacteristics and therefore will earn a differentreturn in the market.
Weighted Ave. Cost of Capital (WACC) •^
Discount rate used when computing the netpresent value of a project of average risk.
-^
Calculated by weighting the cost of each form ofsecurity issued (Common stock, preferred stock,bonds, debentures).
-^
Weights equal to the proportion of each of thecomponents in the capital structure.
Example:
A firm’s capital structure includes $
Million in bonds, $6 Million in equity, and $1Million in preferred stock (market values).
The
firm’s cost of equity is 15%, the cost of debt is8% and the cost of preferreds is 10%.
If the
firm’s marginal tax rate is 50%, what is itsWACC?
Weighted Average Cost of Capital
(^
)^
(^
) (
)^
(^
(^
)^
(^
) (
)^
(^
)
^
^
^
^
^
=^
+^
−^
^
^
^
^
^
+^
+^
+^
+^
+^
^
^
^
^
^
^
^
^
^
^
=^
+^
−^
^
^
^
^
^
+^
+^
+^
+^
+^
^
^
^
^
^
=
f
a^
e^
d^
p
f^
f^
f
E^
D
P
k^
k^
k^
1
T^
k
E^
D
P^
E^
D
P^
E^
D
P
6
3
1
.
.
1
.
6
3
1
6
3
1
6
3
1
11.2%
Docsity.com
Required Rate of Return •^
Risk-free Rate of Return + Risk Premium
-^
Risk-free Rate of Return:^ •
real rate of return (compensation for deferringconsumption) plus compensation for expectedinflation
-^
Risk Premium:
additional reward required for
bearing the risk of an investment^ •
Composed of business risk, financial risk,marketability risk, interest rate risk andseniority risk.
Cost of Debt •^
The firm’s after-tax cost of debt (k
) is found byi
multiplying the firm’s pre-tax cost of debt (k
)d
by 1 minus the firm’s marginal tax rate (T).
•^
Debt is the firm’s lowest cost source of funds,since interest is a tax-deductible expense.
•^
As the amount of debt issued increases, the riskof default rises and so does the cost.
i^
d
k = k
(1 - T)
Cost of Preferreds •^
The firm’s after-tax cost of preferreds (k
) isp
equal to the pre-tax cost (D
/Pp
net
), since
dividends are not tax deductible (dividends arepaid out of after-tax cash flow).
p
p
D^ net
k
=
P