Posted: February 16th, 2023
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Go to www.TeachMeFinance.com – and read topics:
· Cost of Capital, The Cost of Retained Earnings and The Weighted Average Cost of Capital
· View: Capital Budgeting You Tube video: Capital Budgeting
Discussion 1 – Capital Budgeting
Capital budgeting is a complicated process that is essential to good investment decisions by a company. Please give an example of a capital budgeting decision a company might need to make.
Are there examples in using the cost of capital in personal life? When or how have you compared the cost of getting money to the potential benefit of that money?
Once a business computes its cost of capital, discuss how a manager might decide whether to take on a project or not. How are capital project investments prioritized?
Topics
The Firm’s Cost of Capital
Financial and Operating Leverage
Break-Even Analysis
The Firm’s Cost of Capital
In this section, we examine the theory, key concepts, and calculation of the firm’s weighted
average cost of capital and the advantages and disadvantages of each component of that cost to
the firm.
Definition of Cost of Capital
A firm’s cost of capital is the net price it must pay for its total mix of capital financing, both debt
and equity, after considering any tax impact and the floatation costs, which constitute all the
expenses directly related to arranging the financing. This price paid is the cost of capital to the
firm, and is governed, or constrained, primarily by the rate of return required by investors who
are willing to purchase the firm’s securities with the perceived risk associated with them.
The firm’s cost of capital is also the firm’s minimum required rate of return (or hurdle rate) on
any new capital investments. To accept any capital projects with a lower rate of return than the
cost of capital would result in a reduction of shareholder wealth because it would obviously cost
more to finance the capital investment than the return yielded. For most financial decision
making, the relevant cost of capital rate is the “marginal” weighted average cost of capital. This
cost represents the next best available, or marginal, increment of capital that the firm can raise
for future capital expenditures.
Calculating the Cost of Capital
A firm has access to three primary sources of long-term capital, some of which have variations.
These sources are:
1. debt financing market
2. preferred stock financing market
3. common stock financing market
The cost of capital of a firm equals the after-tax and after-flotation weighted average cost of the
individual components of its capital structure, with each component multiplied times its weight
in percent:
Types of Financing Marginal Costs Weight %
1 Debt financing kd wd
2 Preferred stock kps wps
3 Equity financing
3a —Retained earnings kcs wcs
3b —New common stock Kncs wncs
where:
kd = marginal cost of debt financing after tax and flotation costs
kps = marginal cost of preferred stock financing after tax and flotation costs
kcs = marginal cost of retained earnings financing after tax and flotation
costs
kncs = marginal cost of new common stock financing after tax and flotation
costs
and
wd = portion of debt financing to total capital financing in dollars
wps = portion of preferred stock financing to total capital financing in
dollars
wcs = portion of retained earnings financing to total capital financing in
dollars
wncs = portion of new common stock financing to total capital financing in
dollars
Note that in the above table we have broken the cost of capital for equity, ke, into two
subcomponents to account for the different cost structures. Retained earnings, kcs, accounts for
the current market value of previously issued common stock, and represents the charge assigned
to any use of retained earnings cash reserves. New issues of common stock that will incur
flotation costs are represented by Kncs.
As an example of computing component weights, the weight of the debt-financing component is
calculated as follows:
wd = $ debt/($ debt + $ preferred stock + $ retained earnings + $ new common stock)
The weight for the remaining components are calculated in a similar fashion. Using the above-
defined terms, the general formula for the weighted marginal cost of capital is:
kwacc = (wd)(kd) + (wps)(kps) + (wcs)(kcs) + (wncs)(kncs)
Or, to cover the fact that debt capital financing, alone of all the capital components, has a tax
shield impact (1 – Tc), we can expand the formula as shown below to incorporate th
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Introduction to the
Cost of Capital
The Basics of the Cost of Capital
Valuing Different Costs
Approaches to Calculating the Cost of Capital
The WACC
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• Defining the Cost of Capital
• Differences Between Required Return and the Cost of Capital
• Relationship Between Financial Policy and the Cost of Capital
The Basics of the Cost of Capital
Introduction to the Cost of Capital > The Basics of the Cost of Capital
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• If a project is of similar risk to a company’s average business activities, it is
reasonable to use the company’s average cost of capital as a basis for project
evaluation.
• A company’s securities typically include both debt and equity; therefore, one must
calculate both the cost of debt and the cost of equity to determine a company’s
cost of capital.
• Weighted average cost of capital takes into account the amount of financing that
comes through the use of debt and the use of equity.
• IRR is the rate of return that makes the net present value of all cash flows from an
investment equal zero.
Defining the Cost of Capital
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SOLUTION
Capital budgeting is the process of evaluating and selecting long-term investment projects that will generate cash flows in the future. These investments are typically large-scale projects such as building a new factory, expanding an existing business, or launching a new product line. Capital budgeting is a crucial process for businesses as it helps them allocate their financial resources in the most efficient and profitable way.
The capital budgeting process typically involves several steps, including:
Overall, capital budgeting is a critical process for businesses to make informed investment decisions that will help them achieve their long-term financial goals.
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