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1. Introduction to Cost of Capital
1. What is the cost of capital? The cost of capital is essentially the cost to the firm of doing business. If a financial manager invests in a project, they want to know that the firm is earning as much on the project as it costs them to acquire funds to invest in the project. The cost of capital is the overall cost of financing for the firm. It is usually used as the interest rate or discount rate used to calculate the present value of future cash flows generated by a financial asset or a project. The cost of capital is a weighted average of its sources. Those sources are ____, ____ and ____(Critical Concept). See Slide Cost of Capital (63.0K) .
2. Cost of Components of the Capital Structure

A. Calculation of the Cost of Debt. The cost of debt is the effective yield to maturity paid to the bondholders of the firm. In order to calculate the cost of debt capital, first calculate the yield to maturity on the firm's bonds as illustrated in Chapter 10. However, the cost of debt capital is actually less than the firm's yield to maturity. This is because the interest paid by the firm on its debt is tax-deductible. So, the cost of debt capital is the effective yield to maturity, which is ____ due to the tax-deductibility of interest paymentsCritical Concept). The calculation for the cost of debt capital is ________(Critical Concept). It is adjusted for taxes. See Slide Cost of Debt (48.0K) .

B.Calculation of the Cost of Preferred Stock. The cost of preferred stock is not adjusted for taxes. This is because dividends are not tax-deductible. The calculation for the cost of preferred stock is____(Critical Concept). It is higher than the cost of debt since dividends are not tax-deductible and due to higher flotation costs. Flotation costs are____(Key Term). See Slide Cost of Preferred Stock (47.0K) .

C.Calculation of the Cost of Common Equity. There are two accepted methods for calculating the cost of common equity. The first is the dividend valuation model discussed in Chapter 10. The formula is _____(Critical Concept). The second is the Capital Asset Pricing Model, discussed in the chapter appendix. In this chapter, the dividend valuation model is used.

D. Calculation of the Cost of Retained Earnings. The firm uses its retained earnings before it issues new stock. The dividend valuation model is used to calculate the cost of retained earnings. See Slide Cost of Common Equity: Retained Earnings (60.0K) .

E. Calculation of the Cost of New Stock. Once a firm's retained earnings are used, then the firm may issue new shares of its common stock to raise capital. The cost of new common stock is calculated as________(Critical Concept) The only difference in the calculation from the cost of retained earnings is the inclusion of flotation costs. See Slide Cost of Common Equity: New Common Stock (48.0K) .

3. Optimal Capital Structure
1. How to choose the optimal capital structure. The best capital structure for the firm is the one that minimizes the weighted average cost of capital. Usually, some combination of debt, preferred stock and common equity is used. Debt must be kept to a reasonable level or it can raise the ____ risk of the firm(Critical Concept). If too much new equity is issued, owners' earnings will be diluted. See Slide Optimum Capital Structure (54.0K) . The optimal amount of debt varies by industry. See Slide Slide 11 (45.0K) . The _____ cost of capital is the average cost of obtaining financing for the firm(Key Term). It is the cost of each component of the capital structure multiplied by its weight in the capital structure. For a tutorial on weighted average cost of capital, take a look at this website (11017).
2. Marginal Cost of Capital. When all sources of financing, including retained earnings, are exhausted, the firm must issue new stock. At some point, financing for the firm will become more expensive because investors will see the firm as riskier. The retained earnings breakpoint is the point at which financing will become more expensive. The weighted average cost of capital at that point is called the ____(Key Term).