CostofCapital-FacultyandResearch.pptVIP

Cost of Capital Chapter 13 Cost of Capital Defined Cost of capital: percentage cost of permanent funds employed in business, or firm’s capital structure Capital structure: mix of long-term debt and equity by firm for its permanent financing needs Cost of Capital Defined Sample Restructured Balance Sheet (“mix” of company’s permanent financing) Firm only has two categories of assets: net working capital and fixed assets Net working capital is current assets minus current liabilities. “Restructured” right-hand side represents firm’s capital structure such that there are two categories of financing for two categories of assets. Net working Capital Long-term debt Fixed Assets Equity Cost of Capital Defined Two costs of capital Average cost of capital (ACC): weighted average after-tax cost of new capital raised during given year Analysis of current financial decisions requires focus on current costs Marginal cost of capital (MCC): represents incremental ACC as function of total dollar amount of capital raised As increasing amounts of capital are raised, cost of capital begins to increase Increased cost occurs at increments such that MC of additional dollar of capital is greater than AC of capital AC increases more slowly than MC Cost of Capital Defined Consider an analogy of average and marginal tax rates. Example: Corporate tax rate 15% on first $50,000 of income 25% on next $25,000 35% on all income above $75,000 If corporation earned $50,000 before taxes, both average and marginal tax rates are 15%. At $60,000, average tax rate is 16.7% and marginal tax rate is 25%. Above $75,000, marginal tax rate is 35%. Cost of Capital Defined Same general pattern holds for corporate cost of capital as in example. As more capital is raised, cost increases at margin, increasing marginal cost in increments. Average cost increases at slower rate and eventually approached marginal cost. See exhibit 13.2 Marginal Cost and Capital Budgeting MCC is the capital cost that should be used f