Financial Management Case
Chapter 10
The Cost of Capital
Learning Objectives
After reading this chapter, students should be able to:
Explain what is meant by a firm’s weighted average cost of capital.
Define and calculate the component costs of debt and preferred stock. Explain why the cost of debt is tax adjusted and the cost of preferred is not.
Explain why retained earnings are not free and use three approaches to estimate the component cost of retained earnings.
Briefly explain the two alternative approaches that can be used to account for flotation costs.
Briefly explain why the cost of new common equity is higher than the cost of retained earnings, calculate the cost of new common equity, and calculate the retained earnings breakpoint—which is the point where new common equity would have to be issued.
Calculate the firm’s composite, or weighted average, cost of capital.
Identify some of the factors that affect the WACC—dividing them into factors the firm cannot control and those they can.
Briefly explain how firms should evaluate projects with different risks, and the problems encountered when divisions within the same firm all use the firm’s composite WACC when considering capital budgeting projects.
List some problems with cost of capital estimates.
Lecture Suggestions
Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the weighted average cost of capital (WACC), to develop a corporate cost of capital for use in capital budgeting.
We begin by describing the logic of the WACC, and why it should be used in capital budgeting. We next explain how to estimate the cost of each component of capital, and how to put the components together to determine the WACC. We go on to discuss factors that affect the WACC and how to adjust the cost of capital for risk. We conclude the chapter with a discussion on some problems with cost of capital estimates.
What we cover, and the way we cover it, can be seen by
The Cost of Capital
Learning Objectives
After reading this chapter, students should be able to:
Explain what is meant by a firm’s weighted average cost of capital.
Define and calculate the component costs of debt and preferred stock. Explain why the cost of debt is tax adjusted and the cost of preferred is not.
Explain why retained earnings are not free and use three approaches to estimate the component cost of retained earnings.
Briefly explain the two alternative approaches that can be used to account for flotation costs.
Briefly explain why the cost of new common equity is higher than the cost of retained earnings, calculate the cost of new common equity, and calculate the retained earnings breakpoint—which is the point where new common equity would have to be issued.
Calculate the firm’s composite, or weighted average, cost of capital.
Identify some of the factors that affect the WACC—dividing them into factors the firm cannot control and those they can.
Briefly explain how firms should evaluate projects with different risks, and the problems encountered when divisions within the same firm all use the firm’s composite WACC when considering capital budgeting projects.
List some problems with cost of capital estimates.
Lecture Suggestions
Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the weighted average cost of capital (WACC), to develop a corporate cost of capital for use in capital budgeting.
We begin by describing the logic of the WACC, and why it should be used in capital budgeting. We next explain how to estimate the cost of each component of capital, and how to put the components together to determine the WACC. We go on to discuss factors that affect the WACC and how to adjust the cost of capital for risk. We conclude the chapter with a discussion on some problems with cost of capital estimates.
What we cover, and the way we cover it, can be seen by