Cost of Capital Professor Ronald Miolla. Agenda 1) What is Cost of Capital? 2) How to compute Cost of Capital. 3) Cost of debt. 4) Cost of equity.

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Presentation transcript:

Cost of Capital Professor Ronald Miolla

Agenda 1) What is Cost of Capital? 2) How to compute Cost of Capital. 3) Cost of debt. 4) Cost of equity.

A Company’s Cost of Capital The overall cost of getting financing A=L+OE Computation (next slide) gives you a % cost for the average $ that is financed Called a WACC, weighted average cost of capital Can be used to determine a discount rate for the firm

Example Finance ItemCostWeightWeighted Cost Debt (bonds)7.05% *.30= 2.12% Pref. Stock10.94%*.10 = 1.09 Retained Earn12.00%*.60= 7.2 WACC 10.41% Interest on debt reduces taxes Optimal structure is not all debt as financial risk increases with debt in the financing structure.

After Tax Cost of Debt After tax cost % = cost%(1-tax rate) Example: – Tax rate is 35% – After tax % = 10.84%(1-.35) = 7.05%

The Capital Asset Pricing Model (CAPM) Required return stock = risk free return + B(market return – risk free) B is the beta of a stock: a measure of how risky it is compared to the overall market. Over 1 is more risky. Less than 1 is less risky. Example: ? = 3% + 1.5(11-3) = 15%

Summary Cost of Capital is the % cost of funding. Based on the cost of liabilities and equity. Investments/projects must yield returns higher than the Cost of Capital.