cost of capital
rate of return that a firm needs to earn on its projects to maintain the market value of its stock
projects with a rate of return above the cost of capital will
INCREASE the value of the firm
cost of capital acts as a major link between
- firm's long term investment decisions
- wealth of the owners as determined by investors in the market place
business risk
risk to the firm of being unable to cover operating costs ; firm's acceptance of a project does not affect its ability to meet operating costs
financial risks
risk to the firm of being unable to cover required financial obligations; projects are financed in such a way that the firm's ability to meet required projects is unchanged
target capital structure
desired optimal mix of debt and equity financing that most firms attempt to maintain
4 basic sources of long term funds for the business firm:
long term debt
preferred stock
common stock
retained earnings
(all entries on the right hand side of the balance sheet)
cost of long term debt
after tax cost today of raising long term funds through borrowing
net proceeds
funds actually received from the sale of a security
floatation costs
total costs of issuing and selling a security (apply to all public offerings of securities- debt, preferred stock, and common stock)
underwriting costs
compensation earned by investment bankers for selling the security
administrative costs
issuer expenses such as legal, accounting, printing, and other expenses
before tax cost of debt for a bond can be obtained in 3 ways
quotation
calculation
approximation
quotation
when net proceeds from sale of bond = par value, the before tax cost costs = coupon interest rates
-or-
yield to maturity
calculation
calculates the internal rate of return (IRR)
cost of common stock equity
rate at which investors discount the expected dividends of the firm to determine its share value; two techniques: constant growth valuation motel, and CAPM
cost of retained earnings
same as the cost of an equivalent fully subscribed issue of additional common stock
cost of a new issue of common stock
cost of common stock, net of underpricing and associated floatation costs
underpriced
stock sold at a price below its current market price
weighted average cost of capital
reflects the expected average future cost of funds over the long run; found by weighing the cost of each specific type of capital by its proportion in the firm's capital structure
book value weights
use accounting values to measure the proportion of each type of capital in the firm's financial structure
market value weights
measure the proportion of each type of capital in the firm's financial structure ; preferred over book value weights
historical weights
either book or market value weights based on ACTUAL capital structure proportions
target weights
either book or market value weights based on DESIRED capital structure proportions
economic value added
popular but static approach to investment decisions used by many firms to determine whether an investment contributes positively to the owners wealth
break points
level of total new financing at which the cost of one of the financing components rises (causing a shift upward in the weighted marginal cost of capital)
investment opportunities schedule (IOS)
ranking of investment possibilities from best (highest return) to worst (lowest return); usually the the first project selected will have the highest return