BF : Ch12 the cost of capital

what is the cost of capital

it is the minimum required return of the investors for an investment project

what is the cost of capital used for

investment analysis or capital budgeting in

• IRR analysis

• NPV analysis

the cost of capital consists out of different component costs

• equity investors : cost of equity capital Ke

• preferred stock investors : cost of preferred stock capital Kp

• debt investors ; cost of debt capital Ki

cost of equity capital

cost of internal equity capital (internal financing with R/E)

cost of external equity caputal (external financing with issue of new shares)

• when increasing the capital budget the firm goes from cheaper internal financing to more expensive external equity capital

cost of preferred stock capital

expected return of preferred stock

cost of debt capital

expected return of debt

yield to maturity on bonds or interest payment (%) on bank loans

→ but interest payments are tax deductible, so the cost of debt capital should be calculated as an after-tax cost of debt

when increasing the capital budget the firm goed from cheaper smaller loans to more expensive bigger loans or bonds

what should and shouldn’t weights of the weighter average cost of capital reflect

how the company is financed, it’s capital structure

not how the investment project is financed