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12.1 The Cost of Capital Overview

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Define the cost of capital.
  2. Identify the costs associated with the costs of capital such as flotation, administrative and underwriting.

The cost of capitalThe rate of return a firm must supply to investors. is the rate of return that a firm must supply to its investors. If a corporation doesn’t provide enough return, market forces will decrease the prices og their stock and bonds to restore the balance. The cost of capital acts as a link between a firm’s long-run and short-run financial decisions because it ties long-run returns with current costs. We should undertake only projects where the return is greater than the associated cost.

Flotation Costs

Flotation costsCost of issuing and selling a security. are the costs of issuing and selling a security. Typical costs include both underwriting and administrative costs. Administrative costsAny additional costs such as legal, accounting or printing. are any expenses incurred by the issuer of the security including legal, accounting etc. Underwriting costsPayments to the investment banker for issuing the security. are payment to investment bankers for selling the security. When we discuss the cost of capital we are discussing the net proceeds from the sale of any security (bond, stock or any other security). So net proceeds are the total amount received minus any of the above described flotation costs.

Components of WACC

There are several components to the cost of capital for a firm. These are:

  1. Cost of debt
  2. Cost of preferred stock
  3. Cost of common stock

Together these three components are then “weighted” based on the percentages they are used in the company.

Key Takeaways

The cost of capital is the return a company must earn on its investment projects to maintain its market value.

  • Flotation costs are the costs of issuing a security.
  • The components of the cost of capital are 1) debt, 2) preferred stock, 3) common stock.

Exercises

  1. What are flotation costs?
  2. What are administrative costs?
  3. What are underwriting costs?