c9: cost of capital

• All investors (bondholders & stockholders) have required rates of return based on current market conditions. On the other side, a firm must pay market rates on any new capital raised from investors
• a firm’s cost of capital is a marginal cost that depends on current market rates not on historical or past market conditions
• The decision to take on a project depends on the project’s ability to generate cash flows that will satisfy investors. The cost of capital used to make the decision should integrate all investors’ required returns, not just the specific type of new financing used to finance the project. (ie. elon musk is spending a lot)
• •Investors expect to earn rates of return on the full amount at stake, which is the current market value of the investment
• while costs of debt and equity fluctuate due to market conditions, these costs depend more on the future weights that investors expect than on the current, fluctuating, rates. Therefore, the weights used to calculate the WACC should be based on market (not book) values and on the firm’s expected future (or target) weights
• Market conditions, especially interest rates, market risk premium, and tax rates, are beyond the firm’s control
• The firm’s capital structure, dividend policy, and investment policy can be controlled by the firm. firms can choose to stop and start paying dividends at any time they choose
• Firms with riskier projects generally have a higher WACC
• firms can not control the level of interest rates. Rising interest rates increase the cost of debt, which in turn increases the costs of common and preferred equity, and vice versa.
• the Change in the market risk premium affects the cost of equity and thus the WACC. this is something the firm can't control
• firms have no control over Tax rates. While the cost of debt is lower because interest expense is tax deductible, the cost of equity may also be reduced by lowering the capital gains tax rate.
• a firm can control it's choice of Capital structure policy. it's up to them to decide on the optimal capital structure that minimizes its cost of capital
• a firm has control over its Dividend policy. A firm’s payout ratio may affect the stock’s required rate of return. a high payout ratio leads to issuing new capital and incurring flotation costs
• A firm’s marginal cost of capital should reflect the risk of its new investment. a firm can make its own investment policy
• the divisional cost of capital is The cost of capital that reflects the average risk and overall capital structure of the entire firm
• It does not make sense for a firm with multiple divisions with different degrees of risk to use its overall cost of capital (WACC) to evaluate all projects, regardless of risk involved
• cost of capital is Used to decide whether to make an investment in capital projects, compensation plans and to choose the mixture of the firm's debt and equity to finance the firm
• The terms "cost of capital” and “weighted average cost of capital” can be explained using Long-term sources of financing and Capital components
• rd is the required return or cost of debt
• rps is the required return or cost of preferred shares
• rs is the required return or cost of common stock
• ws is the weight of the required return or cost of common stock
• wd is the weight of the required return or cost of debt