CHAPTER 6The Cost of Capital
Sources of ponent costs
Adjusting for flotation costs
Adjusting for risk
PURPOSE:Why Do We Need to Estimate
Used in estimating Economic Value Added
Used to determine whether new projects provide future cash flows sufficient to cover capital costs
Used to regulate natural monopoly service provided by electric, gas and panies
Concept of EVA
Economic Value Added
equals
Net Operating Profit After Tax (NOPAT)
minus
Cost of Capital times Operating Invested Capital
What sources of long-term capital do firms use?
Calculating the weighted average cost of capital
= wdkd(1-T) + wpkp + wcks
The w’s refer to the firm’s capital structure weights.
The k’s refer to the cost of ponent.
Should our analysis focus on before-tax or after-tax capital costs?
Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, . use A-T costs of capital in . Only kd needs adjustment, because interest is tax deductible.
Should our analysis focus on historical (embedded) costs or new (marginal) costs?
The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for ).
How are the weights determined?
= wdkd(1-T) + wpkp + wcks
Use accounting numbers or market value (book vs. market weights)?
Use actual numbers or target capital structure?
Component cost of debt
= wdkd(1-T) + wpkp + wcks
kd is the marginal cost of debt capital.
The yield to maturity on outstanding L-T debt is often used as a measure of kd.
Why tax-adjust, . why kd(1-T)?
A 15-year, 12% semiannual coupon bond sells for $1,. What is the cost of debt (kd)?
Remember, the bond pays a semiannual coupon, so kd = % x 2 = 10%.
INPUTS
OUTPUT
N
I/YR
PMT
PV
FV
30
5
60
1000
-
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