Cost of Capital - Current

Question 1

What is a firm’s cost of capital?

Answer 1

A firm’s cost of capital is typically used to discount the future cash flows of long-term projects, since investments with a return higher than the cost of capital will increase the value of the firm (i.e. shareholders’ wealth

Investors provide funds to corporations with the understanding that management will deploy those funds in such a way that the investor will ultimately receive a return. If management does not generate the investors’ required rate of return, they will take their funds out of the corporation and redirect them to more profitable ventures. For this reason, the investors’ required rate of return (also called their opportunity cost of capital) in turn becomes the firm’s cost of capital

Note: The cost of capital is NOT used in connection with working capital since short-term needs are met with short-term funds

Question 2

What are component costs of capital?

Answer 2

A firm’s financing structure consist of three components: Long-term debt, Preferred equity and Common equity (R/E is treated as part of common equity in this analysis.

The rate of return demanded by holders of each is the component cost for that form of capital:

1. Component cost of debt is the after-tax interest rate on the debt (interest payments are tax-deductible by the firm)

= Effective rate x (1.0 - Marginal tax rate)

2. Component cost of preferred stock is computed using the dividend yield ratio

= Cash dividend on pref. stock / Market price of Pref. stock

3. Component cost of common stock is also computed using the dividend yield ratio

= Cash dividend on common stk. / Market price of CS

Note: If all the relative components are known, the cost of capital can also be computed using CAPM

4. Component cost of R/E is considered to be the same as that for common stock (if the firm cannot find a profitable use for R/e, it should be distributed to the common shareholders in the form of dividends so that they can find their own alternative investments)

Question 3

Why are providers of equity capital exposed to more risk than lenders?

Answer 3

Providers of equity capital are exposed to more risk than are lenders due to the following:

1. The firm is not legally obligated to pay them a return
2. In case of liquidation, equity investors trail creditors in priority

To compensate for this higher level of risk, equity investors demand a higher return, making equity financing more expensive than stock

Question 4

What is a target capital structure?

Answer 4

Corporate management usually designates a target capital structure for the firm (i.e. the proportions that each component of capital should comprise in the overall combination (i.e. 10% debut, 20% preferred stock and 70% common stock)

Question 5

What is weighted-average cost of capital (WACC)?

Answer 5

A firm’s weighted-average cost of capital (WACC) is a single, composite rate of return on its combined components of capital

The weights are based on the components’ respective market values (not book values) because the market value provides the best information about investors’ expectations

Question 6

What is the optimal capital structure?

Answer 6

Standard financial theory provides a model for the optimal capital structure of every firm. This model holds that shareholder wealth-maximization results form minimizing the weighted-average cost of capital. Thus, the focus of management should NOT be on maximizing earnings per share (EPS can be increased by taking on more debt, but debt increases risk)