Access over 20 million homework & study documents

Debt and Euity Cost management

Content type
User Generated
Type
Study Guide
Rating
Showing Page:
1/13
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 1 of 13
The Cost of Capital
In previous classes, we discussed the important concept that the
expected return on an investment should be a function of the
“market risk” embedded in that investment – the risk-return
tradeoff.
The firm must earn a minimum of rate of return to cover the cost of
generating funds to finance investments; otherwise, no one will be
willing to buy the firm’s bonds, preferred stock, and common
stock.
This point of reference, the firm’s required rate of return, is called
the COST OF CAPITAL.
The cost of capital is the required rate of return that a firm must
achieve in order to cover the cost of generating funds in the
marketplace. Based on their evaluations of the riskiness of each
firm, investors will supply new funds to a firm only if it pays them
the required rate of return to compensate them for taking the risk of
investing in the firm’s bonds and stocks. If, indeed, the cost of
capital is the required rate of return that the firm must pay to
generate funds, it becomes a guideline for measuring the
profitabilities of different investments. When there are differences
in the degree of risk between the firm and its divisions, a risk-
adjusted discount-rate approach should be used to determine their
profitability.
WWW: To get information on a specific company, you might want to check
the annual report (www.reportgallery.com) and the 10-K report
(www.sec.gov/edgarhp.htm). The inputs for estimating the market value of
debt and equity should be available in these sources. You can get a beta
from the daily stocks web site (www.dailystocks.com). To get an extensive
risk profile of a firm, visit the web site maintained by www.riskview.com.
What more information, such as data on analyst coverage and views of the
stock? Try Zacks Investment Research (www.zachs.com). There are many
other web sites on the Internet with a wealth of information.
www.yahoo.com is just one place to start searching for company info.

Sign up to view the full document!

lock_open Sign Up
Showing Page:
2/13
Case Studies in Corporate Finance
Cost of Capital Teaching Note
By Dr. Betty Simkins
Page 2 of 13
What impacts the cost of capital?
The Cost of Capital becomes a guideline for measuring the
profitabilities of different investments.
Another way to think of the cost of capital is as the opportunity
cost of funds, since this represents the opportunity cost for
investing in assets with the same risk as the firm. When investors
are shopping for places in which to invest their funds, they have an
opportunity cost. The firm, given its riskiness, must strive to earn
the investor’s opportunity cost. If the firm does not achieve the
return investors expect (i.e. the investor’s opportunity cost),
investors will not invest in the firm’s debt and equity. As a result,
the firm’s value (both their debt and equity) will decline.
Remember that: The goal of the corporation is to maximize the
value of shareholders’ equity!
RISKINESS
OF
EARNINGS
INTEREST RATE
LEVELS IN THE
US/GLOBAL
MARKETPLACE
THE DEBT
TO
EQUITY
MIX OF
THE FIRM
FINANCIAL
SOUNDNESS
OF THE FIRM

Sign up to view the full document!

lock_open Sign Up
Showing Page:
3/13

Sign up to view the full document!

lock_open Sign Up
End of Preview - Want to read all 13 pages?
Access Now
Unformatted Attachment Preview
The Cost of Capital In previous classes, we discussed the important concept that the expected return on an investment should be a function of the “market risk” embedded in that investment – the risk-return tradeoff. The firm must earn a minimum of rate of return to cover the cost of generating funds to finance investments; otherwise, no one will be willing to buy the firm’s bonds, preferred stock, and common stock. This point of reference, the firm’s required rate of return, is called the COST OF CAPITAL. The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firm’s bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, it becomes a guideline for measuring the profitabilities of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability. What impacts the cost of capital? The Cost of Capital becomes a guideline for measuring the profitabilities of different investments. Another way to think of the cost of capital is as the opportunity cost of funds, ...
Purchase document to see full attachment
User generated content is uploaded by users for the purposes of learning and should be used following Studypool's honor code & terms of service.

Anonymous
Excellent! Definitely coming back for more study materials.

Studypool
4.7
Trustpilot
4.5
Sitejabber
4.4