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1、,Irwin/McGraw-Hill,Chapter 11,Fundamentals of Corporate FinanceThird Edition,The Cost of Capital,Brealey Myers Marcusslides by Matthew Will,Irwin/McGraw-Hill,The McGraw-Hill Companies,Inc.,2001,Topics Covered,Geothermals Cost of CapitalWeighted Average Cost of Capital(WACC)Capital StructureRequired
2、Rates of ReturnBig Oils WACCInterpreting WACCFlotation Costs,Cost of Capital,Cost of Capital-The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk.Capital Structure-The firms mix of long term financing and equity financing.,Cost of Capital
3、,Example Geothermal Inc.has the following structure.Given that geothermal pays 8%for debt and 14%for equity,what is the Company Cost of Capital?,Cost of Capital,Example-Geothermal Inc.has the following structure.Given that geothermal pays 8%for debt and 14%for equity,what is the Company Cost of Capi
4、tal?,Cost of Capital,Example-Geothermal Inc.has the following structure.Given that geothermal pays 8%for debt and 14%for equity,what is the Company Cost of Capital?,Cost of Capital,Example-Geothermal Inc.has the following structure.Given that geothermal pays 8%for debt and 14%for equity,what is the
5、Company Cost of Capital?,Interest is tax deductible.Given a 35%tax rate,debt only costs us 5.2%(i.e.8%x.65).,WACC,Weighted Average Cost of Capital(WACC)-The expected rate of return on a portfolio of all the firms securities.Company cost of capital=Weighted average of debt and equity returns.,WACC,WA
6、CC,Three Steps to Calculating Cost of Capital1.Calculate the value of each security as a proportion of the firms market value.2.Determine the required rate of return on each security.3.Calculate a weighted average of these required returns.,WACC,Taxes are an important consideration in the company co
7、st of capital because interest payments are deducted from income before tax is calculated.,WACC,Weighted-average cost of capital=,WACC,Example-Executive Fruit has issued debt,preferred stock and common stock.The market value of these securities are$4mil,$2mil,and$6mil,respectively.The required retur
8、ns are 6%,12%,and 18%,respectively.Q:Determine the WACC for Executive Fruit,Inc.,WACC,Example-continuedStep 1 Firm Value=4+2+6=$12 milStep 2Required returns are givenStep 3,WACC,Issues in Using WACC Debt has two costs.1)return on debt and 2)increased cost of equity demanded due to the increase in ri
9、skBetas may change with capital structureCorporate taxes complicate the analysis and may change our decision,Measuring Capital Structure,In estimating WACC,do not use the Book Value of securities.In estimating WACC,use the Market Value of the securities.Book Values often do not represent the true ma
10、rket value of a firms securities.,Measuring Capital Structure,Market Value of Bonds-PV of all coupons and par value discounted at the current interest rate.,Market Value of Equity-Market price per share multiplied by the number of outstanding shares.,Measuring Capital Structure,Measuring Capital Str
11、ucture,If the long term bonds pay an 8%coupon and mature in 12 years,what is their market value assuming a 9%YTM?,Measuring Capital Structure,Required Rates of Return,BondsCommon Stock,Required Rates of Return,Dividend Discount Model Cost of EquityPerpetuity Growth Model=solve for re,Required Rates
12、of Return,Expected Return on Preferred StockPrice of Preferred Stock=solve for preferred,Flotation Costs,The cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.Only the incremental costs of financing should be included.This is sometimes called Adjusted Present Value.,
