FIN 614: Financial Management
Larry Schrenk, Instructor
1. What is the Cost of Capital?
2. Importance of Cost of Capital
3. Weighted Average Cost of Capital
(WACC)
Return on assets depends on their risk
Return to an investor is the same as the cost
to the company
Cost of capital indicates of how market
views the risk of our assets
Can help determine required return for
capital budgeting projects
Required return is the appropriate discount
rate and is based on the risk of cash flows
Must know the required return before we can
compute the value of an investment
Must earn at least the required return to
compensate our investors
Capital as Firm Input
Minimize Cost of Inputs
Minimize Cost of Capital
Whether to invest in some
potential projects.
For example, should a firm buy
a new production line?
From a project, must earn at least
the required return
Required return is the same as the
appropriate discount rate based on
the risk of the project.
How to decide the appropriate
discount rate?
Also called:
Cost of Capital
Hurdle Rate
Discount Rate
One possibility: Assume the new
project has the same risk as the
existing firm.
Use required return on the firm’s
existing assets as the discount rate for
the new project.
But what if the new project has risk
very different from the existing
business?
Company Cost of Capital (CoC) is the
required return on the existing firm assets
based on their risk.
The risk of firm’s overall assets is equal to the
weighted average risks of firm’s debt,
preferred stock and common equity.
Thus the cost of capital of a firm equals the
weighted average (WACC) of the cost of
debt, the cost of preferred stock, and the
cost of common equity.
WACC is the weighted average of the
after-tax cost of each of the sources
capital used by a firm to finance its
project, where the weight reflects the
proportion of total financing raised from
each source.
Internal
Retained Earnings
External
Debt
Equity
Pecking Order
WACC  wdrd(1– t c )  wprp  w srs
Weights (Weighted Average)
Required Returns
Tax Effect
wi = weight of asset
ri = return on asset
tc = corporate tax rate
FIN 614: Financial Management
Larry Schrenk, Instructor