Lecture 7 – Cost of Capital

Question 1

What are the three main sources of financing?

Answer 1

Main source of financing:
1) Equity (Common and/or Preferred)
2) Debt (Bank Loans and/or Bonds)
3) Retained earnings

Question 2

What is the cost of capital?

Answer 2

the cost of capital is:

• The return required by investors (equity and bond holders) for investing in the firm
• The opportunity cost of capital by investing in the firm

Question 3

is interest on debt tax dedeutible?

Answer 3

Interest paid is tax deductible
The company has tax savings due to debt

Question 4

Should we use the market values of debt and equity in the WACC or the historical (accounting) values?

Answer 4

The cost of capital must be based on what investors are actually willing to pay today for the company’s outstanding securities.

Don’t use the book value to compute Equity value.

For Debt value, it depends… Bank debt vs Long term debt.
But book value can provide useful information to estimate their market value.

Question 5

Whats the use of WACC?

Answer 5

The usage of WACC?
Valuing new projects related to the existing operations of the company (i.e., average-risk projects)
Examples
Starbucks considers buying a new coffee machine
McDonalds considers introducing a new burger in the market
Boeing considers manufacturing a new type of airplane