Managerial finance -- Chapter 11

the cost of capital
terms

Cost of capital -- the rate of return that a firm must earn on the projects in which it invests to maintain its market value and attract funds
business risk -- the risk to the firm of being unable to cover operating costs
financial risk -- the risk to the firm of being unable to cover required financial obligations (interest, lease payments, preferred stock dividends)
target capital structure -- the desired optimal mix of debt and equity financing that most firms attempt to maintain
cost of long-term debt -- the after-tax cost today of raising long-term funds through borrowing
net proceeds -- funds actually received from the sale of the security
flotation costs -- the total costs of issuing in selling a security
cost of preferred stock -- the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock; calculated by dividing the annual dividend, by the net proceeds from the sale of the preferred stock
cost of common stock equity -- the rate at which investors discount the expected dividend of the firm to determine its share value
constant growth valuation (Gordon) model -- assume is that the value of a share of stock equals the present value of all future dividends (assumed to grow at a constant rate) that it is expected to provide over an infinite time horizon
capital asset pricing model (CAPM) -- describes the relationship between the required return, and the nondiversifiable risk of the firm as measured by the beta coefficient
cost of retained earnings -- the same as the cost of on equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity
costs of new issue of common stock -- the cost of common stock, net of underpricing and associated flotation costs
underpriced -- stock sold at a price below its current market price
weighted average cost of capital (WACC) -- reflects the expected average future cost of funds over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure
book value weights -- weights that use accounting values to measure the proportion of each type of capital in the firm's financial structure
market value weights -- weights that use market values to measure the portion of each type of capital in the firm's financial structure
historical weights -- either book or market value weights based on actual capital structure proportions
target weights -- either book or market value weights based on desired capital structure proportions
economic value added (EVA) -- a popular measure used by many firms to determine whether an investment contributes positively to the owner's wealth; calculated as the difference between an investments net operating profit after taxes (NOPAT) and the cost of funds used to finance the investment, which is found by multiplying the dollar amount of the funds used to finance the investment by the firm's weighted average cost of capital (WACC)
weighted marginal cost of capital (WMACC) -- the firm's weighted average cost of capital (WACC) associated with its next dollar of total new financing
breakpoint -- the level of total new financing at which the cost of one of the financing components rises, thereby causing an upward shift in the weighted marginal cost of capital (WMACC)
weighted marginal cost of capital (WMCC) schedule -- graph that relates the firm's weighted average cost of capital to the level of total new financing
investment opportunities schedule (IOS) -- a ranking of investment possibilities from best (highest return) to worst (lowest return)