Chapter 9

In computing the cost of capital, which sources of capital do we consider?

1) The financial objective of management is to maximize the shareholders' wealth. We can increase the value of the common stock by lowering the firm's cost of capital. All else remaining the same, as the cost of capital decreases, the value of the firm increases. 2) The cost of capital is used as the minimum acceptable rate of return for capital investments. The value of the firm is maximized by accepting all projects where the net present value is positive when discounted at the firm's cost of capital.

Why do we calculate a firm's weighted average cost of capital?

1) The financial objective of management is to maximize the shareholders' wealth. We can increase the value of the common stock by lowering the firm's cost of capital. All else remaining the same, as the cost of capital decreases, the value of the firm increases. 2) The cost of capital is used as the minimum acceptable rate of return for capital investments. The value of the firm is maximized by accepting all projects where the net present value is positive when discounted at the firm's cost of capital.

Weighted AVG Cost of Capital

A composite of the individual costs of financing incurred by each capital source. A function of: 1) The individual costs of capital 2) The capital structure mix

What's the difference between internal common equity and new common stock?

Equity capital can be raised either by retaining profits (internal common equity) within the firm or by issuing new common stock. Either route represents funds invested by the common stockholder. The first avenue simply indicates that the common stockholder permits management to retain capital that could be remitted to these investors.

Why is a cost associated with internal common equity?

Even though retaining earnings (internal common equity) appears to be a low-cost source of funds, these funds should not be reinvested unless management can reasonably expect to satisfy the investors' required rate of return. In essence, even though no explicit out-of-pocket cost results from retaining the capital, the cost in measuring a firm's cost of capital is actually the opportunity cost associated with these funds for the investor.

What is the effect of the flotation costs associated with a new security issue?

In completing a security offering, investment bankers and other involved individuals receive a commission for their services and for the expenses of issuing a new security. As a result, the amount of capital raised, net of these flotation costs, is less than the funds invested by the individual purchasing the security. Consequently, the firm must earn more than the investors' required rate of return to compensate for this leakage of capital.

Define the term Cost of Capital

The cost of capital is the rate of return that the firm must earn on its investments in order to satisfy the required rates of return of all the firm's sources of financing (including creditors who loan the firm money and owners who purchase shares of stock in the company). This rate is a function of the required rates of return for all the firm's sources of financing, the corporation's tax rate, and the flotation costs incurred in issuing new securities. Therefore, the cost of capital determines the rate of return that must be achieved on the company's investments to earn the target return of the firm's investors.

How does a firm's tax rate affect its cost of capital?

The effect of taxes on the firm's cost of capital is observed in computing the cost of debt. Because interest is a tax-deductible expense, the use of debt decreases the firm's taxes compared to the use of equity. Therefore, we compute the cost of debt on an after-tax basis.

Financial Policy

The firm's policies regarding the sources of financing it plans to use and the particular mix in which they will be used

What might we expect to see in practice in the relative costs of different sources of capital?

The investor's required rate of return increases as additional risk is expected. Comparing historical pre-tax returns, the observed rates of return on debt are less than those of equity, on average. Given that interest expense is tax-deductible, whereas dividends are not, there is usually a cost advantage to issuing debt. Between types of equity, preferred stock usually carries a lower required return compared to common equity due to the protection provided to preferred shareholders wherein preferred stock dividends must be paid before dividends on common stock are paid. Hence, common equity carries a greater level of risk and usually has a higher required rate of return

Capital Structure

The mix of long-term sources of funds used by the firm. Also called the firm's capitalization. The relative total of each type of fund is emphasized.

Describe two approaches that could be used in computing the cost of common equity

The two popular methods for computing the cost of equity capital include (1) the dividend-growth model (2) the capital asset pricing model. The first approach finds the rate of return that equates the present value of expected future dividends, assuming a constant growth rate, with the current market price of the security. The CAPM finds the appropriate required rate of return, given the risk-free rate (the time value of money), the return on the market portfolio, and the firm's level of systematic risk.