COST OF CAPITAL-1

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Cost of Capital and Capital Structure Issues:

Cost of Capital and Capital Structure Issues How can decisions about the way investments are financed enhance stockholders’ value?

The corporation’s cost of capital is the rate of return that must be earned on investment projects. It is the discount rate that should be used when calculating the present value of cash flows from an investment.:

The corporation’s cost of capital is the rate of return that must be earned on investment projects. It is the discount rate that should be used when calculating the present value of cash flows from an investment.

Securities are priced in the market by investors such that they earn the rate of return they require for taking the risk the investment entails.:

Securities are priced in the market by investors such that they earn the rate of return they require for taking the risk the investment entails.

The rate of return required by investors is also a measure of the cost of capital to the corporation who issued the securities.:

The rate of return required by investors is also a measure of the cost of capital to the corporation who issued the securities.

For example::

For example: Assume that Carnival Cruise Lines, Inc. has bonds outstanding that are priced to provide investors a yield of 8 percent. It follows that if Carnival wanted to raise new funds by selling more bonds, they would need to pay investors 8 percent. Thus, 8 percent is Carnival’s cost of debt capital.

Another example::

Another example: Assume that MGM Grand, Inc. had common stock outstanding, priced to provide investors a 16 percent return. It follows that if MGM wanted to raise new funds by selling more stock, they would need to provide investors a 16 percent return on their investment. Thus, 16 % is MGM’s cost of equity.

In general then, investors’ valuations of securities implies corporations’ cost of capital. We can use the same mathematical models used for valuation to compute corporate cost of capital.:

In general then, investors’ valuations of securities implies corporations’ cost of capital. We can use the same mathematical models used for valuation to compute corporate cost of capital.

More specifically::

More specifically: The cost of debt is the yield-to-maturity found by using the bond valuation equation. The cost of preferred stock is the required return found by using the preferred stock valuation equation. [k = Div/Price] The cost of equity is the required return found by using the common stock valuation equation. [k = D 1 /Price + g] OR , by the CAPM formula.

A business will usually use several sources of long-term financing.:

A business will usually use several sources of long-term financing. The optimal proportions of financing that should be raised from each source is called the optimal capital structure. For example, a business might have an optimal capital structure that consists of 30 percent debt, 10 percent preferred stock, and 60 percent common equity.

Since all of the several sources of financing in the optimal capital structure will be used over time, the corporation should calculate its weighted average cost of capital (WACC) from all sources.:

Since all of the several sources of financing in the optimal capital structure will be used over time, the corporation should calculate its weighted average cost of capital (WACC) from all sources.

For example::

For example: Consider again the business whose optimal capital structure was 30 % debt, 10 % preferred stock, and 60% common equity. Assume investors require an 8% return on bonds, a 12% return on preferred stock, and a 16% return on common stock. The business’ WACC = (.30 x .08) + (.10 x .12) + (.60 x .16) = 13.2%.

In order to satisfy its investors, a business must invest in projects that earn at least the WACC.:

In order to satisfy its investors, a business must invest in projects that earn at least the WACC. When investments are made in projects that earn more than the WACC, common stockholders wealth is increased. Such projects are ones with NPV > 0, or IRR > Cost of capital

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