Understanding Cost of Capital in Finance
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ScribdTranslationsUnderstanding Cost of Capital in Finance
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ScribdTranslationsChapter 9
What is the cost of capital?
It is the reflection of the expected average cost of long-term funds in the future and of the
totality of the company's financing activities.
What role does the cost of capital play in long-term investment decisions?
What is the company's deadline? What relationship exists between the cost of capital and capacity?
of the company to maximize shareholder wealth?
That the cost of capital is the fundamental criterion for evaluating opportunities
investment of the company
What does the capital structure of the company represent?
Cumplir el objetivo de la compañía, en términos de maximizar la riqueza de los
shareholders. The activities related to this process occupy a place
a priority among the responsibilities of financial managers, and that does not
they can be implemented without knowing the appropriate cost of capital.
9-4 What are the typical long-term capacity sources available to the
company?
Long-term debt
Preferred shares
Common stocks
Retained earnings
What are the net income derived from the sale of a bond? What are the
floatation costs and how they affect the net income of a bond?
Funds that the company actually receives from the sale of a security. They represent the
funds that the company receives from that transaction.
From the net proceeds, flotation costs are deducted, which represent the expense.
total realized from the issuance and sale of the securities.
9-6 What methods can be used to determine the cost of debt before
taxes?
Use of market quotes:
It consists of observing the yield to maturity (YTM) of the bonds with which it is already
account the company, or the bonds with a similar level of risk issued by others
companies. The RAV of the existing bonds reflects the yield rate
required by the market. For example, if the market requires a RAV of 9.7 for
one hundred for a bond with a similar risk level, this value can be used as
cost of debt before taxes, kd, for the new bonds. The
bond yields have a wide dissemination in sources such as the Wall
Street Journal.
Cost calculation:
This method determines the cost of debt before taxes by means of
calculation of the RAV generated by the cash flows of the bond, taking into
consideration of the net income that the company receives when it issues such
obligation. From the issuer's perspective, this value is the cost at maturity
of the cash flows associated with the debt. The RAV can be estimated using
a financial calculator or a spreadsheet. It represents the
annual percentage of the cost of debt before taxes.
Calculation by approximation:
Although less precise than using a calculator, there is a method to estimate
quickly the cost of debt before taxes through approximation. The
cost of debt before tax, kd, of a bond with a par value of 1,000
Dollars can be roughly calculated this way:
9-7 What procedure should be followed to convert the cost of debt before
taxes on the cost after taxes?
COST OF DEBT AFTER TAXES
Unlike the dividends that are distributed to shareholders, the
interest payments made to bondholders are deductible from
taxes for the company, so interest expenses on debt decrease
your taxable income and therefore, your tax liability. To determine the cost
net debt of the company, we must consider the tax savings created
for the debt, and seek the cost of long-term debt after taxes,
that is why we multiply the pre-tax cost, kd, by one minus the
tax rate, T.
9-8 How is the cost of preferred stock calculated?
The cost of preferred stock, kp, is the ratio between the dividend of the
common stocks and the net income obtained by the company from the
sale of preferred shares. The net income represents the amount of money
that will be received, minus any flotation costs that may exist. The equation
the following results in the cost of preferred shares, kp, in terms of
annual dividend in monetary units, Dp, and the net income generated by
the sale of the shares.
9–9 What is the premise proposed by the constant growth model (or of
Gordon growth) on stock value, and it is used to measure the
cost of capital of common stocks, ks?
It is the dividend discount model that assumes the growths that
The experiments of the company are constant. It is based on the theory that the price
the value of a stock must be equal to the price of the dividends it will deliver
company, discounted to their current net value.
If the stock price in the market is lower than the result obtained by the
discounted dividend model, the stock is undervalued and therefore, it is
recommended to buy. If, on the contrary, the market price is higher than that of
It is understood that the price per share is too high.
9-10 What are the differences between the growth valuation model?
constant and the capital asset pricing model regarding the
determination of the cost of common stocks?
The CAPM technique differs from the constant growth valuation model in
that directly takes into account the company's risk, reflected by its
beta coefficient, in the determination of the required return or the cost of
capital of common shares. For its part, the valuation model of
constant growth does not consider risk; instead, it uses the price of
market, P0, as a reflection of the risk-return preference expected
by the investors who participate in the market. In theory, the techniques of
CAPM and constant growth valuation to determine r are
equivalents, but in practice the resulting values in each case are not always
They coincide. Each method can generate different estimates because they require
(as computing data) calculations of different amounts, such as the expected rate
of dividend growth or the company's beta coefficient.
9–11 What is the reason for the cost of financing a project with profits?
held should be less than the cost of financing it through the issuance of new ones
common actions?
The net proceeds generated from the sale of the new common shares will be
lower than the current market price. Therefore, the cost of the new
emissions will always be higher than the cost of existing emissions, which is
equal to the cost of retained earnings. The cost of new shares
common is generally greater than that of any other cost of financing
in the long term.
9–12 What is the weighted average cost of capital (WACC) and how is it calculated?
The Weighted Average Cost of Capital (WACC) is a financial measure, to
like other financial indicators, this one has a specific purpose and it is
to encompass in a single number expressed in percentage terms The
companies can calculate their weighted values based on the book value or
in the market value, using either historical proportions or
target proportions.
9–13 What relationship exists between the company's target capital structure and the
weighted average cost of capital (WACC)?
Considerations of book value or market value that are based on the
desired proportions of the capital structure average cost of capital
weighted: it results extremely complex and that the results are prone to
error, which causes investment decisions to become chaotic. If a
a company undervalues its cost of capital, risks making investments without
economic justification, and if it overvalues them, it could overlook investments
capable of maximizing value.
9–14 Describe the underlying logic in the use of target weights for
calculate the CCPP, and compare this method with the use of weights
historical. What is the best weighting scheme?
The book value weights use accounting values to measure the
proportion of each type of capital present in the financial structure of the
company. On its part, the market value weights measure the
proportion of each type of capital considering its market value. The
market value weights are attractive because market values
the financial instruments approach the amount of real money that is
would receive for their sale. Furthermore, if we take into account that companies calculate
the costs of the various types of capital through market prices
current, it seems reasonable to use market value weights. On the other hand
side, the capital flows related to long-term investments to which
the cost of capital is applied, calculated in terms of market values
current and future. It is evident that the market value weights have
more supporters than the weightings of book value.