8/11/2019 financaa

1/21

After reading this chapter, students should be able to:

Explain what is meant by a firms weighted average cost of capital.

Define and calculate the component costs of debt and preferred stock.

Explain why retained earnings are not free and use three approaches to

estimate the component cost of retained earnings.

riefly explain why the cost of new e!uity is higher than the cost of

retained earnings, calculate the cost of new e!uity, and calculate the

retained earnings breakpoint""which is the point where new e!uity would

have to be issued.

riefly explain the two alternative approaches that can be used to account

for flotation costs.

#alculate the firms composite, or weighted average, cost of capital.

$dentify some of the factors that affect the overall, composite cost of

capital.

riefly explain how firms should evaluate pro%ects with different risks,

and the problems encountered when divisions within the same firm all use

the firms composite &A## when considering capital budgeting pro%ects.

'ist and briefly explain the three separate and distinct types of risk that

can be identified, and explain the procedure many firms use when developing

sub%ective risk"ad%usted costs of capital.

(se the #A)* to directly estimate the cost of capital for specific pro%ects

or divisions.

$dentify and explain the two approaches that have been used to estimate

individual assets betas.

'ist some problem areas in estimating the cost of capital.

Harcourt, Inc. Learning Objectives: 10 - 1

Chapter 10The Cost of Capital

LEARNING OBJECTIVES

8/11/2019 financaa

2/21

#hapter + uses the rate of return concepts covered in previous chapters,

along with the concept of the weighted average cost of capital -&A##, to

develop a corporate cost of capital for use in capital budgeting.

&e begin by describing the logic of the &A##, and why it should be used

in capital budgeting. &e next explain how to estimate the cost of each

component of capital, and how to put the components together to determine the

&A##. &e go on to discuss factors that affect the &A##, how to ad%ust the

cost of capital for risk, and estimating pro%ect risk. /hen, we discuss how

to use the #A)* to estimate the risk"ad%usted cost of capital, and we discuss

techni!ues for measuring beta risk. &e conclude the chapter with a discussion

on some problem areas in the cost of capital.

/he details of what we cover, and the way we cover it, can be seen by

scanning Blueprints, #hapter +. 0or other suggestions about the lecture,

please see the 1'ecture 2uggestions3 in #hapter 4, where we describe how we

conduct our classes.

DA52 67 #8A)/E9: 60 ;< DA52 -;"minute periods

Lecture Suggestions: 10 - 2 Harcourt, Inc.

LECTURE SUGGESTIONS

8/11/2019 financaa

3/21

8/11/2019 financaa

4/21

effect on the stability of the firms earnings. 2tand"alone risk refers

to the inherent riskiness of the pro%ects expected returns when viewed

alone. /heoretically, beta -market risk is the most relevant measure

because of its effect on stock prices.

+" /he cost of capital for average"risk pro%ects would be the firms cost

of capital, + percent. A somewhat higher cost would be used for morerisky pro%ects, and a lower cost would be used for less risky ones. 0or

example, we might use +4 percent for more risky pro%ects and @ percent

for less risky pro%ects. /hese choices are arbitrary.

+" Each firm has an optimal capital structure, defined as that mix of debt,

preferred, and common e!uity that causes its stock price to be

maximiBed. A value"maximiBing firm will determine its optimal capital

structure, use it as a target, and then raise new capital in a manner

designed to keep the actual capital structure on target over time. /he

target proportions of debt, preferred stock, and common e!uity, along

with the costs of those components, are used to calculate the firms

weighted average cost of capital, &A##.

/he weights could be based either on the accounting values shown onthe firms balance sheet -book values or on the market values of the

different securities. /heoretically, the weights should be based on

market values, but if a firms book value weights are reasonably close

to its market value weights, book value weights can be used as a proxy

for market value weights. #onse!uently, target market value weights

should be used in the &A## e!uation.

+"; An increase in the risk"free rate will increase the cost of debt.

9emember from #hapter ;, k C k90 = D9) = ') = *9). /hus, if k90increases so does k -the cost of debt. 2imilarly, if the risk"free

rate increases so does the cost of e!uity. 0rom the #A)* e!uation, ksC

k90= -k* k90b. #onse!uently, if k90increases kswill increase too.

+" $n general, failing to ad%ust for differences in risk would lead the

firm to accept too many risky pro%ects and re%ect too many safe ones.

6ver time, the firm would become more risky, its &A## would increase,

and its shareholder value would suffer.

Answers and Solutions: 10 - ' Harcourt, Inc.

8/11/2019 financaa

5/21

+"+ F Debt> F E!uity> kdC @F> / C F> &A## C @.@F> ksC G

&A## C -wd-kd-+ " / = -wc-ks

.@@ C -.-.@-+ " . = -.ks.@@ C .4+ = .ks.H< C .ks ksC +F.

+"4 )pC IH.;> DpC I. kpC G

kpC

)

D

p

p

kpCIAH.;,

I:.

8/11/2019 financaa

6/21

+"H kpCI@4.+;

I+,,-,.++C

I@4.+;

I++C ++.@F.

+"< a. ksC

,

+

)

D= g

ksC ,.,E=I:E

I:.+