FIN 614: Financial Management Larry Schrenk, Instructor.

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FIN 614: Financial Management Larry Schrenk, Instructor

1.What is the Cost of Capital? 2.Importance of Cost of Capital 3.Weighted Average Cost of Capital (WACC)

Return on assets depends on their risk Return to an investor is the same as the cost to the company Cost of capital indicates of how market views the risk of our assets Can help determine required return for capital budgeting projects

Required return is the appropriate discount rate and is based on the risk of cash flows Must know the required return before we can compute the value of an investment Must earn at least the required return to compensate our investors

Capital as Firm Input Minimize Cost of Inputs Minimize Cost of Capital

Whether to invest in some potential projects. For example, should a firm buy a new production line?

From a project, must earn at least the required return Required return is the same as the appropriate discount rate based on the risk of the project. How to decide the appropriate discount rate?

Also called: Cost of Capital Hurdle Rate Discount Rate

One possibility: Assume the new project has the same risk as the existing firm. Use required return on the firm’s existing assets as the discount rate for the new project. But what if the new project has risk very different from the existing business?

Company Cost of Capital (CoC) is the required return on the existing firm assets based on their risk. The risk of firm’s overall assets is equal to the weighted average risks of firm’s debt, preferred stock and common equity. Thus the cost of capital of a firm equals the weighted average (WACC) of the cost of debt, the cost of preferred stock, and the cost of common equity.

WACC is the weighted average of the after-tax cost of each of the sources capital used by a firm to finance its project, where the weight reflects the proportion of total financing raised from each source.

Internal Retained Earnings External Debt Equity Pecking Order

Weights (Weighted Average) Required Returns Tax Effect w i = weight of asset r i = return on asset  c = corporate tax rate

FIN 614: Financial Management Larry Schrenk, Instructor

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