# Master

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Submitted By alkoholev
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Pages 5
The Weighted Average Cost of Capital
Cost of Capital – the cost that a firm must pay for the capital it uses to finance new investments and investment projects.
Capital comes from: 1) Debt 2) Preferred stock 3) Retained earnings 4) Common stock
Alternatively:
Cost of Capital to the firm is the equilibrium rate of return demanded by investors in the capital markets for securities in that risk class. So, it is the minimum rate of return required on new investments undertaken by the firm.

The role of cost of capital in capital budgeting:
If IRR on New Investment > Cost of Capital ( Value of firm rises ( Stock Price rises
If IRR on New Investment < Cost of Capital ( Value of firm falls ( Stock Price falls

Why is the Cost of Capital equal to the return investors require?
Because when the investors give the firm their money, they expect to earn a return commensurate with the risk of that project or firm. Therefore, at a minimum the firm must earn at least the Expected Return, E(R), that investors require. So the E(R) from the Capital Asset Pricing Model (CAPM) (and similar models) becomes the minimum rate that the firm must earn to satisfy investors and this rate becomes one component of the relevant discount rate used in capital budgeting decisions.

Computing the Cost of Capital for Each Component
Cost of Equity Capital (Common Stock)
Recall the CAPM [pic]
Where: [pic] is the return on the [pic] stock, [pic] is the return on the Risk Free asset, [pic] is the return on the market, [pic] is the measure of systematic risk. eg. t-bill Rate=7% [pic]

How to calculate [pic]? 1) Book shows formula, but this is just the slope in a 2 variable regression of [pic] on [pic]. Could plot data, draw line, and get slope. 2) Look it up: Value Line, Merrill Lynch, Yahoo, etc.
So,

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