Intro to Financial Management

1. Intro to Financial Management Cost of Capital

2. Review Exam

3. Cost of Capital = k • The minimum required rate of return on a new investment. • A weighted return • Costs of financing from each of the sources • Includes • Required returns • Risk premium • Cost of financing • Firm evaluates potential investments relative to the cost of capital • Also known as “hurdle rate”

4. Cost of Capital • Related to required rate of return • Have to account for taxes. • Bond interest is tax deductible, dividends are not • Use factor (1 – tax rate) • Have to account for transaction costs • Deduct the cost of issuing the stock or bond from the nominal price and compute • Use the net proceeds from the sale in place of the price in the calculations

5. Cost of Capital • Debt • Solve for I/Y where PV = net proceeds • E.g. if sell $1,000 bonds may get only $980, use as PV • Then take result and adjust for tax treatment k = interest rate * (1 – tax rate) • Preferred stock • Use net proceeds instead of stock price k = dividend / net proceeds

6. Debt Example

7. Cost of Common Stock • No permanent dividend or interest paid • Incur cost when float stock • No transaction costs on retaining earnings • Dividend growth model – use when float stock k = (D / net proceeds) + g • CAPM – use when retain earnings k = rf + β (rm – rf) Assumes no transaction costs

8. Common Stock Example

9. Weighted Average Cost of Capital • Take the cost of each source of funding and weight it by it’s percent of the total • Weight x k • Add all the (weight x k)’s • Used by firm in investment decisions • The expected return must be greater than the cost of capital • In practice • Weights may change each year • Use the firm’s target capital structure

10. Divisional Cost of Capital • Firm may be in many businesses • Each may have different risk characteristics • Adjust k for risk in each division • Evaluate each division using it’s own k