Beruflich Dokumente
Kultur Dokumente
2007 Thomson/South-Western
Essentialsof
Chapter11
What types of capital do firms use to finance
investments?
What is the cost of capital?
How is the cost of capital used to make
financial decisions?
Why do funds generated through retained
earnings have a cost?
Who determines a firms cost of capital?
Cost of Capital
Firms average cost of funds, which is
the average return required by firms
investors
What must be paid to attract funds
Basic Definitions
Capital Component
Types of capital used by firms to raise
money
rd
rdT
rps
rs
re
Basic Definitions
WACC
Weighted Average Cost of Capital
Capital Structure
A combination of different types of
capital(debt and equity) used by a
firm
rps
D ps
NP
D ps
P0 Flotation costs
D ps
P0 (1 F)
D
1 g r
r r
RP
s RF
s
P
0
10
11
P
0
D
1
D
2
1 rs 1 rs
1
D
t
t
t 1 1 r
s
1 rs
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D
1
D
2
1 rs 1 rs
1
1 rs
D
D
t
1 if g is constant
t k g
t 1 1 r
s
s
D
1
r r
g
s s P
0
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The Bond-Yield-Plus-Premium
Approach
Estimating a risk premium above
the bond interest rate
Judgmental estimate for premium
Ballpark figure only
D
D
1
1
r
g
g
s NP
P 1 F
0
15
16
cost
of
of
preferred
preferred
of
common
common
wd
rdT
w ps
rps
ws
rs
17
18
MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
WACC3=11.5%
11.5 WACC2=11.0%
11.0 10.5 -
WACC1=10.5%
100
150
New Capital
Raised (millions
of dollars)
19
20
MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
WACC3=11.5%
WACC2=11.0%
WACC1=10.5%
New Stock,
Preferred,
Expensive Debt
New Stock,
Preferred,
Cheap Debt
RE,
Preferred,
Cheap Debt
BPRE
100
BPDebt
150
MCC Schedule
Schedule and break points depend
on capital structure used
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MCC Schedule
Weighted Average Cost of Capital
(WACC) (%)
Smooth, or Continuous,
Marginal Cost of Capital
Schedule
WACC
0-
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IRRB = 11.7%
IRRD = 11.5%
IRRE = 11.3%
WACC3=11.0%
MCC
WACC2=10.5%
10.0 -
WACC1=10.0%
Optimal Capital
Budget - $115
20
40
60
80
160
25
Chapter 11 Essentials
What types of capital do firms use to finance
investments?
Either debt (bond issues) or equity (preferred stock and
common equity)
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Chapter 11 Essentials
Why do funds generated through
retained earnings have a cost?
Firms may retain earnings only as long as it
can reinvest the earnings at a higher rate
than stockholders can earn elsewhere
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