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Lecture Introduction to finance: Markets, investments, and financial management (14th edition): Chapter 18 - Melicher, Norton

Chapter 18 - Capital structure and the cost of capital. This chapter includes contents: Explain how capital structure affects a firm’s capital budgeting discount rate, explain how a firm can determine its cost of debt financing and cost of equity financing, explain how a firm can estimate its cost of capital,. | Chapter 18 Capital Structure and the Cost of Capital © 2011 John Wiley and Sons Chapter Outcomes Explain how capital structure affects a firm’s capital budgeting discount rate. Explain how a firm can determine its cost of debt financing and cost of equity financing. Explain how a firm can estimate its cost of capital. Describe how a firm’s growth potential, dividend policy, and capital structure are related. Chapter Outcomes, continued Explain how EBIT/eps analysis can assist management in choosing a capital structure. Describe how a firm’s business risk and operating leverage may affect its capital structure. Describe how a firm’s degree of financial leverage and degree of combined leverage can be computed and explain how to interpret their values. Describe the factors that affect a firm’s capital structure. What is Capital Structure? Capital structure is the mix of debt and equity An optimal debt/equity mix will minimize the firm’s cost of capital A lower cost of capital means a higher firm value Required Rate of Return and the Cost of Capital Project cost = $1000 Financed by: $600 debt at 9% interest (pre-tax) $400 equity with a 15% return requirement Minimum Required Returns Annual pre-tax cash flow = $600 (0.09) + $400 (0.15) = $114 Minimum pre-tax return = 114/$1000 = 11.4% or: = $600/$1000 (9%) + $400/$1000(15%) =11.4% Three Names, Same Concept Required rate of return—investor Cost of capital (or weighted average cost of capital)—firm Discount rate—NPV calculation Why a Weighted Average? In most cases, the weighted average cost of capital should be used in project evaluation, NOT project-specific financing costs This month: accept project with IRR of 9% and is debt-financed at 8% Later this year: reject project with IRR of 12% that was to be equity financed at 15% This is not a value-maximizing strategy! Computing Capital Costs After-tax cash flows require the use of after-tax financing costs Incremental cash flows require | Chapter 18 Capital Structure and the Cost of Capital © 2011 John Wiley and Sons Chapter Outcomes Explain how capital structure affects a firm’s capital budgeting discount rate. Explain how a firm can determine its cost of debt financing and cost of equity financing. Explain how a firm can estimate its cost of capital. Describe how a firm’s growth potential, dividend policy, and capital structure are related. Chapter Outcomes, continued Explain how EBIT/eps analysis can assist management in choosing a capital structure. Describe how a firm’s business risk and operating leverage may affect its capital structure. Describe how a firm’s degree of financial leverage and degree of combined leverage can be computed and explain how to interpret their values. Describe the factors that affect a firm’s capital structure. What is Capital Structure? Capital structure is the mix of debt and equity An optimal debt/equity mix will minimize the firm’s cost of capital A lower cost of capital