Chapter 13
COST OF CAPITAL
1 OBJECTIVE
#Managing the right-hand-side of the B/S
#By now, for valuation analysis, we know:
!criteria: NPV, IRR, payback
!what the relevant CFs are
!how to compute net CFs
!how to introduce forecast error in CFs (WHAT IF,. . . )
#Sources of financing:
Debt, equity, retained earnings, preferred stock, warrants, venture capital, and bank loans, strategic alliances.
!Bank loans, venture capital, and warrants not discusd
荠菜的作用和功效!To simplify, we concentrate only on debt, equity, and retained earnings.
#Cost of financing = cost of capital = ?
!Definition:The rate that must be earned to satisfy the
required rate of return of the firm's investors.
!What is the cost of each source of financing?
!What is a project's cost of capital?
#Why might cost of capital in Japan be lower than in U.S.?我的儿子英文
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2 MOTIVATION
2.1 WHY IS COST OF CAPITAL IMPORTANT?
嘴角痣相图解
春风古诗袁枚If financing cost is reduced Y NPV increas Y more projects end up with NPV > 0 Y more wealth created to shareholders.
2.2SOME PRELIMINARIES
!Minimum required return / cost of capital= that particular discount rate “k” that makes NPV = 0.
!The return generated by a curity is the cost of that curity to the company that issued it.
]
剪纸英语cost of capital to the firm = reward to investors.
!The cost of capital depends primarily on the u of funds, i.e., the risk of the CFs, not on the source.
Q risk of CFs (systematic risk)
Q company capital structure
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2.3 COST COMPONENTS
Ca 1Assume firm has no debt & has retained earnings.
Remember from the chapter on Performance Measures:
Net Income = total dividend + retained earnings
If a company cannot find profitable projects, i.e., projects with return
at least equal to k
s , then the firm should distribute retained earnings
to shareholders as dividends.
Thus, if the company is retaining your money, then the minimum acceptable reward to you (an average investor) is the required return
on equity Y required return on retained earnings = k
s / required
return on equity.
But reward to investor = cost of capital to the firm.
ˆrequired return on equity = cost of retained earnings.
Ca 2
Now suppo firm needs to issue new equity for an expansion project. Obviously
k e > k
s
怎么改变自己
] (cost of new equity) > (cost of retained earnings) ]
(required return on new equity) > (required return on retained earnings)
since some transactions (floatation) costs have to be paid to investment banks for assisting firm in lling the new curities.
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Ca 3
If a company has a "good" project (NPV > 0), should it be financed using equity?
Not necessarily, firm should consider using debt.
2.4 OUTLINE
Given a company's target capital structure,
Step 1:Estimate cost of each component
Step 2:Calculate the cost of the combination of financing sources, i.e., company WACC
©, 1997
