CHAPTERS IN THIS PART
11 The Cost of Capital
12 Leverage and Capital Structure
13 Dividend Policy
INTEGRATIVE CASE 4
O’GRADY APPAREL COMPANY
The Cost of Capital
This chapter introduces the student to an important financial concept, the cost of capital. The mechanics of computing thesources of capital-debt, preferred stock, common stock, and retained earnings are reviewed. The relationship between the cost of capital and both the firm's financing activities and capital investment decisions is explored. In the framework of a target capital structure, the weighted average cost of capital is then applied to capital investment decisions.
PMF Tutor: Cost ofCapital
Topics from this chapter covered in the PMF Tutor are after-tax cost of debt; cost of preferred stock; cost of common stock, CAPM; cost of common stock, constant growth; cost of new common stock; and weighted average cost of capital.
PMF Problem- Solver: Cost of Capital
This module allows the student to determine the following: 1) cost of long-term debt (bonds), 2) cost of preferredstock, 3) cost of common stock, 4) weighted average cost of capital, and 5) weighted marginal cost of capital.
Spreadsheet templates are provided for the following problems:
11-6 Cost of preferred stock
11-7 Cost of common stock equity–CAPM
Suggested Study Guide examples for classroom presentation:
7 Weighted average cost ofcapital
8 Marginal cost of capital schedule
ANSWERS TO REVIEW QUESTIONS
11-1 The cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital provides a benchmark against which the potential rate of return on an investment is compared..
11-2 Holding business risk constant assumes that the acceptance ofa given project leaves the firm's ability to meet its operating expenses unchanged. Holding financial risk constant assumes that the acceptance of a given project leaves the firm's ability to meet its required financing expenses unchanged. By doing this it is possible to more easily calculate the firm's cost of capital, which is a factor taken into consideration in evaluating new projects.11-3 The cost of capital is measured on an after-tax basis in order to be consistent with the capital budgeting framework. The only component of the cost of capital that actually requires a tax adjustment is the cost of debt, since interest on debt is treated as a tax-deductible expenditure. Measuring the cost of debt on an after-tax basis reduces the cost.
The use of the weighted averagecost of capital is recommended over the cost of the source of funds to be used for the project. The interrelatedness of financing decisions assuming the presence of a target capital structure is reflected in the weighted average cost of capital.
11-4 In order to make any such financing decision, the overall cost of capital must be considered. This results from the interrelatedness offinancing activities. For example, a firm raising funds with debt today may need to use equity the next time, and the cost of equity will be related to the overall capital structure, including debt, of the firm at the time.
11-5 The net proceeds from the sale of a bond are the funds received from its sale after all underwriting and brokerage fees have been paid. A bond sells at a discount when therate of interest currently paid on similar-risk bonds is above the bond's coupon rate. Bonds sell at a premium when their coupon rate is above the prevailing market rate of interest on similar-risk bonds.
Flotation costs are fees charged by investment banking firms for their services in assisting in selling the bonds in the primary market. These costs reduce the total proceeds received...