Chapter 10 - The cost of capital. Chapter 10 applies these lessons in a managerial finance setting. This chapter also focus is on the cost of capital or, more precisely, the weighted average cost of capital (WACC). | Chapter 10 The Cost of Capital Learning Goals Understand the key assumptions, the basic concept, and the specific sources of capital associated with the cost of capital. Determine the cost of long-term debt and the cost of preferred stock. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of commons stock. Learning Goals (cont.) Calculate the weighted average cost of capital (WACC) and discuss alternative weighting schemes and economic value added (EVA). Describe the procedures used to determine break points and the weighted marginal cost of capital (WMCC). Explain the weighted marginal cost of capital (WMCC) and its use with the investment opportunities schedule (IOS) to make financing and investment decisions. An Overview of the Cost of Capital The cost of capital acts as a link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is the . | Chapter 10 The Cost of Capital Learning Goals Understand the key assumptions, the basic concept, and the specific sources of capital associated with the cost of capital. Determine the cost of long-term debt and the cost of preferred stock. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of commons stock. Learning Goals (cont.) Calculate the weighted average cost of capital (WACC) and discuss alternative weighting schemes and economic value added (EVA). Describe the procedures used to determine break points and the weighted marginal cost of capital (WMCC). Explain the weighted marginal cost of capital (WMCC) and its use with the investment opportunities schedule (IOS) to make financing and investment decisions. An Overview of the Cost of Capital The cost of capital acts as a link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is the “magic number” that is used to decide whether a proposed investment will increase or decrease the firm’s stock price. Formally, the cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. The Firm’s Capital Structure Some Key Assumptions Business Risk—the risk to the firm of being unable to cover operating costs—is assumed to be unchanged. This means that the acceptance of a given project does not affect the firm’s ability to meet operating costs. Financial Risk—the risk to the firm of being unable to cover required financial obligations—is assumed to be unchanged. This means that the projects are financed in such a way that the firm’s ability to meet financing costs is unchanged. After-tax costs are considered relevant—the cost of capital is measured on an after-tax basis. Assume the ABC company has the following investment opportunity: - Initial Investment = $100,000 - Useful Life = 20 years - IRR = 7%
