CHAPTER 9 Estimating The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC
What costs should we focus on? Focus on ______________ costs (only debt is affected). Because cost of capital is used primarily as input to capital budgeting, we are interested in the cost of ______ financing (not historical costs).
Sources of common equity. Sources of common equity financing: Companies can sell new shares of _________________________. Companies can _____________.
There is an opportunity cost for retained earnings. Why? Earnings can be reinvested or paid out as dividends. Unless the firm can earn a rate of return on retained earnings that is acceptable to its shareholders, it should pay a dividend instead.
Three ways to determine the cost of equity, rs: 1. CAPM: rs = rRF + (rM - rRF)b = rRF + (RPM)b. 2. DCF: rs = D1/P0 + g. 3. Own-Bond-Yield-Plus-Risk Premium: rs = BTrd + RP.
What’s the WACC? The weighted average cost of capital, or WACC, is the annual percentage cost of financing a project of average risk (risk equal to firm’s existing assets).
What factors influence a company’s WACC? ______________________ conditions. Firm’s _________________ structure. The firm’s _______________________ policy. Firms with riskier assets have a higher WACC.
Should the company use the firm’s composite WACC as the hurdle rate for all of its projects? Why or why not? NO! The WACC reflects the risk of an average project for the firm. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s ______.
What procedures are used to determine the risk-adjusted cost of capital for a particular project or division? 1.___________________ adjustments to the firm’s composite WACC. 2.Estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project’s _____________.
Why is the cost of retained earnings cheaper than issuing new common stock? results in _________________ costs. may depress _______________ price.
Comments about flotation costs: Flotation costs depend on the type of capital being raised. The flotation costs are highest for common equity. Flotation costs are sometimes ignored when estimating the WACC.
Four Mistakes to Avoid 1. When estimating the cost of debt, use the current interest rate on new debt. 2. For the CAPM approach, use the current long-term T-bond rate and the historical value for the market risk premium. (More ...)
3. Use the target capital structure to determine the weights. If you don’t know the target weights, then use the current market value of equity, and if available, the market value of the firm’s debt. (More...)
4. Capital components are sources of funding that come from investors. __________________ liabilities do not come from investors, so are not included in the calculation of the WACC.