Corporate Finance Cost of Capital - 4513 Words

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 retained earnings are not free and use three approaches to estimate the component cost of retained earnings. †¢ Briefly explain why the cost of new equity is higher than the cost of retained earnings, calculate the cost of new equity, and calculate the retained earnings breakpoint--which is the point where new equity would have to be issued. †¢ Briefly explain the two alternative approaches that can be used to account for flotation costs. †¢ Calculate†¦show more content†¦+ + + 10-2 Beta (market) risk refers to the project’s effect on the corporate beta coefficient. Within-firm (corporate) risk refers to the project’s effect on the stability of the firm’s earnings. Stand-alone risk refers to the inherent riskiness of the project’s expected returns when viewed alone. Theoretically, beta (market) risk is the most relevant measure because of its effect on stock prices. [pic] 10-3 The cost of capital for average-risk projects would be the firm’s cost of capital, 10 percent. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12 percent for more risky projects and 9 percent for less risky projects. These choices are arbitrary. 10-4 Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm’s weighted average cost of capital, WACC. The weights could be based either on the accounting values shown on the firm’s balance sheet (book values) or on the market values of the differentShow MoreRelatedCritique on Mm Theory1159 Words   |  5 Pageseconomist Franco Modigliani and Merton H. Miller published The Cost of Capital, Corporation Finance and the Theory of Investment (Hereafter MM theory); a paper presented the initial MM theory, which states that under a certain market price p rocess, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm s capital is raised by issuing stock or selling debt. It does notRead MoreArticles Relating to Capital Structure-Essay1658 Words   |  7 PagesContents :- Introduction on Capital Structure†¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦..5 Summary and Evaluation of Articles†¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦6 Conclusion†¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦..8 References/Bibliography†¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦.9 â€Æ' Introduction On Capital Structure :- In the field of finance capital structure means a way an organization or firms finances their assets by the way of some mix and match of Equity, Debt or Hybrid Securities. The modern thinking on capital structure is based on the Modigliani-Miller theorem given by Franco ModiglianiRead MoreWhy Do Firms Choose Their Capital Structure?1623 Words   |  7 Pageswondering about which securities to acquire and how to finance those investments: with equity, debt or a combination of both (Myers, 2001). The study of capital structure tries to clarify this variety of securities and financing opportunities. In accounting terms, this decision is situated on the right-hand side of the balance sheet (Myers, 2001). In his Capital Structure Puzzle article, Myers (1984) poses the question â€Å"How do firms choose their capital structure?†. But even today, there is no right solutionRead MoreFinancial Capital Structure Essays1549 Words   |  7 PagesContents : Introduction on Capital Structure Summary and Evaluation of Articles Conclusion References/Bibliography Introduction On Capital Structure :- In the field of finance capital structure means a way an organization or firms finances their assets by the way of some mix and match of Equity, Debt or Hybrid Securities. The modern thinking on capital structure is based on the Modigliani-Miller theorem given by Franco Modigliani and Merton Miller. The theorem suggests that in a perfectRead MoreCapital Asset Pricing Model ( Capm )1310 Words   |  6 Pagesprojects to be invested in or finance in to increase the value of the company. However, to increase the value of the company, firm need to choose the worth pursuing project. In this case, firm need to evaluate the projects which the evaluation of a project can be done by cash flow method. The paper depicts how weight average of cost capital is used as a source of a discount rates for capital budgeting. In this paper, the discount rate in the weight average of cost capital (WACC) will be used in theRead MoreHill Country638 Words   |  3 Pagesquality products in its industry. It has unique capital structure with zero debt and large cash balance corresponding to its conservative operation strategy and corporate culture and philosophy. Whether to change to a more aggressive capital strategy and what is the optimal level of debt-to-capital ratio for Hill Country is the key issue in this case. * Hill Country’s operation strategy and its corporate culture The company commits to operating and cost efficiency with high quality products andRead MoreSyllabus: Corporate Finance and Business Journal/newspaper Article1123 Words   |  5 PagesBUSI K4003 Corporate Finance Syllabus Summer 2012, (Summer Q) Instructor: Brendan Mallee bm2115@columbia.edu Class Time/Location: July 2nd – August 8th MW 6:10-9:30pm / Hamilton Hall 516 Course Description: This course examines important issues in corporate finance from the perspective of financial managers who are responsible for making significant investment and financing decisions. The course is designed to develop critical corporate finance skills including: financial statementRead MoreCapital Structure Of A Firm1670 Words   |  7 PagesThe capital structure of a firm describes the way in which a firm raised capital needed to establish and expand its business activities. It is a mixture of various types of equity and debt capital a firm maintained resulting from the firms financing decisions. In one way or another, business activity must be financed. Without finance to support their fixed assets and working capital requirements, business could not exist. In all aspects of capital investment decision, the capital structure decisionRead MoreUniversity of Phoenix Corporate Finance Syllabus1329 Words   |  6 Pages| Syllabus School of Business FIN/571 Version 5 Corporate Finance | Copyright  © 2011, 2010, 2009, 2008 by University of Phoenix. All rights reserved. Course Description This course applies corporate finance concepts to make management decisions. Students learn methods to evaluate financial alternatives and create financial plans. Other topics include cash flows, business valuation, working capital, capital budgets, and long-term financing. Policies Faculty and students/learnersRead MoreWeighted Average Cost of Capital and Midland Energy1750 Words   |  7 Pages$248.5 billion and operating income of $42.2 billion. The company has been in business for over 120 years and employed more than 80,000 individuals. Janet Mortensen, the senior vice president of project finance for Midland Energy Resources, has been asked to calculate the weighted average cost of capital (WACC) for the company as a whole, as well as each of its three divisions as part of an annual budgeting process. Midland’s Three Divisions: Exploration Production Oil exploration and production (EP)