Cost of Capital

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Cost of Capital

• Chapter 11 Discussion Questions

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Why do we use the overall cost of capital for
investment decisions even when an investment will
be funded by only one source of capital (for
example, debt)?

• Though an investment financed by low-cost debt
  might appear acceptable at first glance, the use
  of debt could increase the overall risk of the
  firm and eventually make all forms of financing
  more expensive.
• Each project must be measured against the overall
  cost of funds to the firm.

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2. How does the cost of a source of capital
relate to the valuation concepts presented in
Chapter 10?

• The cost of a source of financing directly
  relates to the required rate of return for that
  means of financing.
• The required rate of return is used to establish
  valuation..

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3. In computing the cost of capital, do we use
the historical cost of existing debt equity or
the current costs as determined by the market?
Why?

• In computing the cost of capital, we use the
  current costs for the various sources of
  financing rather than the historical costs.
• We must consider what these funds will cost us to
  finance projects in the future rather than their
  past.

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4. Why is the cost of debt less the cost of
preferred stock is both securities are priced to
yield 10 in the market?

• Even though debt and preferred stock may be both
  priced to yield 10 in the market, the cost of
  debt is less because the interest on debt is a
  tax-deductible expense.
• A 10 market rate of interest on debt will only
  cost a firm in a 40 tax bracket an aftertax rate
  of 6.
• The answer is the yield multiplied by the
  difference of (one minus the tax rate).

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5. What are the two sources of equity
(ownership) capital for the firm?

• The two sources of equity capital are
• Retained Earnings and
• new Common Stock

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6. Explain why retained earnings has an
opportunity cost associated with it?

• Retained earnings belong to the existing common
  shareholders.
• If the funds are paid out instead of reinvested,
  the shareholders could earn a return on them.
• Thus we say retaining funds for reinvestment
  carries an opportunity cost.

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7. Why is the cost of retained earnings the
equivalent of the firms own required rate of
return on common stock (Ke)?

• Because shareholders can earn a return at least
  equal to their present investment.
• For this reason, the firm's rate of return (Ke)
  serves as a means of approximating the
  opportunities for alternate investments.

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8. Why is the cost of new common stock (Kn)
higher than the cost of retained earnings (Ke)?

• In issuing new common stock, we must earn a
  slightly higher return than the normal cost of
  common equity in order to cover the distribution
  costs of the new security.

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9. How are the weights determined to arrive at
the optimal weighted average cost of capital?

• The weights are determined by examining different
  capital structures and using that mix which gives
  the minimum cost of capital.
• We must solve a multidimensional problem to
  determine the proper weights.

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10. Explain the traditional, U-shaped approach to
the cost of capital?

• The logic of the U-shaped approach to cost of
  capital can be explained through Figure 11-1.
• It is assumed that as we initially increase the
  debt-to-equity mix the cost of capital will go
  down.
• After we reach an optimum point, the increase use
  of debt will increase the overall cost of
  financing to the firm.
• Thus we say the weighted average cost of capital
  curve is U-shaped.

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11. Identify other variables (ratios) besides the
debt-to-equity ratio that influence a companys
cost of capital.

• Other possible ratios influencing the cost of
  capital might be
• times interest earned
• fixed charge coverage
• and indirectly
• net income / sales
• net income / total assets
• net income / shareholders equity

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12. It has often been said that if the company
cant earn a rate of return greater than the cost
of capital, it should not make investments.
Explain.

• If the firm cannot earn the overall cost of
  financing on a given project, the investment will
  have a negative impact on the firm's operations
  and will lower the overall wealth of the
  shareholders.
• Clearly, it is undesirable to invest in a project
  yielding 8 percent if the financing cost is 10
  percent.

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13. What effect would inflation have on a
companys cost of capital? (Hint think about how
inflation influences interest rates, stock
prices, corporate profits growth)

• Inflation can only have a negative impact on a
  firm's cost of capital-forcing it to go up.
• This is true because inflation tends to increase
  interest rates and lower stock prices, thus
  raising the cost of dent and equity directly and
  the cost of preferred stock indirectly.
• Note, however, that a proper cost of capital
  calculation requires marginal and current market
  costs.
• As such the component costs reflect market
  participants inflationary expectations.

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14. What is the concept of marginal cost of
capital?

• The marginal cost of capital is the cost of
  incremental funds.
• After a firm reaches a given level of financing,
  capital costs will go up because the firm must
  tap more expensive sources.
• For example, new common stock may be needed to
  replace retained earnings as a source of equity
  capital.

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15. What limitations are there in using the
dividend valuation model to determine the cost of
equity capital?

• The dividend valuation model suggests that
  investors required rates of return are based on
  future dividends.
• Does this fully reflect investors required
  returns?
• Furthermore future dividends that must be
  projected are difficult to determine, and the
  growth model assumes growth at a constant rate
  forever.
• The growth rate must also be translated into
  dividends flowing through to shareholders.
• The model must also assume that the share price
  is efficiently determined.

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16. What is the justification for using market
value weightings rather than book value
weightings?

• Investors base their expected returns on their
  market value investment, not on how much they had
  invested at some time in the past.
• The costs of financing in an efficient market are
  based on the market value capital structure and
  not on how the books report that structure.