Financial management -- Chapter 11 -- summary

The cost of capital is an extremely important rate of return used by the firm in the long-term decision process, particularly in capital budgeting decisions. It is the expected average future cost to the firm of funds over the long run. Because the cost of capital is the pivotal rate of return used in the investment decision process, its accuracy can significantly affect the quality of these decisions.

Even with good estimates of project cash flows, the application of NPV and IRR decisions techniques, and adequate consideration of project risk, a poorly estimated cost of capital can result in the destruction of shareholder value. Underestimation of the cost of capital can result in the mistaken acceptance of poor projects, whereas over estimation can cause good projects to be rejected. In either situation, the firm's action could be detrimental to the firm's value. By applying the proper techniques to estimate the firm's cost of capital, the financial manager can improve the likelihood that the firm's long-term decisions will be consistent with the firm's overall goal of maximizing stock price (owner wealth).

Cost of capital
The cost of capital is the rate of return the firm must earn on its investments to maintain its market value and attract needed funds. It is affected by business and financial risks, and is measured on an after-tax basis. A weighted average cost of capital should be used to find the expected average future cost of funds over the long run. The specific costs of the basic sources of capital (long-term debt, preferred stock, retained earnings, and common stock) can be calculated individually.

Determine the cost of long-term debt and preferred stock
The cost of long-term debt is the after-tax cost today of raising long-term funds through borrowing. Cost quotations, calculation, or approximation can be used to find a before tax cost of debt, which must then be tax adjusted. The cost of preferred Stock is the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock.

Calculating the cost of common stock equity and conversion to cost of retained earnings
The cost of common stock equity can be calculated by using the constant growth valuation (Gordon) model or the CAPM. The cost of retained earnings is equal to the cost of common stock equity. Adjustment and the cost of common stock equity to reflect underpricing implication costs is necessary to find the cost of new issues of common stock.

WACC & EVA
The firm's WACC reflects the expended average future cost of funds over the long run. It combines the costs of specific types of capital after weighting each of them by its proportion. The theoretically preferred approach uses target weights based on market values. Economically value added (EVA) is a popular measure that uses the WACC to determine whether a proposed investment is expected to make a positive contribution to the owner's wealth.

Determining breakpoints
As total new financing increases, the costs of the various types of financing will increase, raising the firm's WACC. The WMCC is the firm's WACC associated with its next dollar of total new financing. Break points represent the level of total new financing at which the cost of one of the financing components rises, causing an upward shift in the WMCC. The WMCC schedule relates to the WACC to each level of total new financing.

WMCC & IOS
The IOS ranks currently available investments from best to worst. It is used with the WMCC to find the level of financing/investment that maximizes owner wealth. The firm accepts projects up to the point at which the marginal return on its investment equals is weighted marginal cost of capital.