Chapter 13, the cost of capital. After studying this chapter you will be able to: Explain what the cost of capital represents and why it is so important, estimate the cost of equity using the dividend growth model approach and the security market line approach, estimate the cost of debt and the cost of preferred stock, understand when it is appropriate and to use the WACC as a measure of the firm's required rate of return,. | Fundamentals of Corporate Finance, 3/e Robert Parrino, . David S. Kidwell, . Thomas W. Bates, . 1 Copyright© 2015 John Wiley & Sons, Inc. Chapter 13: The Cost of Capital Learning Objectives Explain what the weighted average cost of capital for a firm is and why it is often used as a discount rate to evaluate projects Calculate the cost of debt for a firm Calculate the cost of common stock and the cost of preferred stock for a firm Copyright© 2015 John Wiley & Sons, Inc. 3 Learning Objectives Calculate the weighted average cost of capital for a firm, explain the limitations of using a firm’s weighted average cost of capital as the discount rate when evaluating a project, and discuss the alternatives to the firm’s weighted average cost of capital Copyright© 2015 John Wiley & Sons, Inc. 4 The Firm’s Overall Cost of Capital Since unique risk can be eliminated by holding a diversified portfolio, systematic risk is the only risk that investors require compensation for bearing. We concluded in Chapter 7 that we could rely on the CAPM to arrive at the expected rate of return for a particular investment. In this chapter, we address the practical concerns that can make that concept difficult to implement. The Firm’s Overall Cost of Capital Firms do not issue publicly traded shares for individual projects As a result, firms have no way to directly estimate the discount rate that reflects the risk of the incremental cash flows from a particular project Financial managers deal with this problem by estimating the cost of capital for the firm as a whole and then requiring analysts within the firm to use this cost of capital to discount the cash flows for all projects A problem with this approach is that it ignores the fact that a firm is really a collection of projects with varying levels of risk The Finance Balance Sheet Accounting Balance Sheets reflect book values Left-hand side: book value of the firm’s assets, based on historical costs Right-hand side: how those | Fundamentals of Corporate Finance, 3/e Robert Parrino, . David S. Kidwell, . Thomas W. Bates, . 1 Copyright© 2015 John Wiley & Sons, Inc. Chapter 13: The Cost of Capital Learning Objectives Explain what the weighted average cost of capital for a firm is and why it is often used as a discount rate to evaluate projects Calculate the cost of debt for a firm Calculate the cost of common stock and the cost of preferred stock for a firm Copyright© 2015 John Wiley & Sons, Inc. 3 Learning Objectives Calculate the weighted average cost of capital for a firm, explain the limitations of using a firm’s weighted average cost of capital as the discount rate when evaluating a project, and discuss the alternatives to the firm’s weighted average cost of capital Copyright© 2015 John Wiley & Sons, Inc. 4 The Firm’s Overall Cost of Capital Since unique risk can be eliminated by holding a diversified portfolio, systematic risk is the only risk that investors require compensation for bearing.
