Chapter 12: The Cost of Capital

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the percentages of the total capital represented by the debt and equity

Capital Structure Weights

the return that lenders require on the firm's debt

Cost of Debt

the return that equity investors require on their investment in the firm

Cost of Equity

fixed dividend divided by the current price per share of the preferred stock

Cost of Preferred Stock

An approach that assumes dividends grow at a constant rate in perpetuity. The price per share of the stock equals next periods projected dividend divided by the return that the shareholders require on the stock minus the growth rate

Dividend Growth Model Approach

A company that focuses only on a single line of business

Pure Play

Use of a weighted average cost of capital that is unique to a particular project, based on companies in similar lines of business.

Pure Play Approach

Calculates the cost of equity as a function of risk-free rate, the market risk premium, and beta

Security Market Line Approach

An approach that involves making subjective adjustments to the overall WACC

Subjective Approach

The particular mixture of debt and equity a firm chooses to employ

Target Capital Structure

the overall return the firm must earn on its existing assets to maintain the value of its stock

Weighted Average Cost of Capital (WACC)


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