Essay on Long-Term Financial Decisions

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Long-Term Financial Decisions


11 12 13

The Cost of Capital Leverage and Capital Structure Dividend Policy



The Cost of Capital

Overview This chapter introduces the student to an important financial concept, the cost of capital. The mechanics of computing the sources of capital-debt, preferred stock, common stock, and retained earnings are reviewed. The relationship between the cost of capital and both the firm's financing activities and capital investment decisions is explored. In the framework of a target capital structure, the weighted average cost of capital is then applied to capital investment decisions.
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2. The rate of growth of dividends and earnings is constant, which means that the firm has a fixed payout ratio. 3. Firms perceived by investors to be equally risky have their expected earnings discounted at the same rate. 11-10 The cost of retained earnings is technically less than the cost of new common stock, since by using retained earnings (cash) the firm avoids underwriting costs, as well as possible underpricing costs.


Chapter 11 The Cost of Capital

11-11 The weighted average cost of capital (WACC), k a , is an average of the firm's cost of long-term financing. It is calculated by weighting the cost of each specific type of capital by its proportion in the firm's capital structure 11-12 Using target capital structure weights, the firm is trying to develop a capital structure which is optimal for the future, given present investor attitudes toward financial risk. Target capital structure weights are most often based on desired changes in historical book value weights. Unless significant changes are implied by the target capital structure weights, little difference in the weighted marginal cost of capital results from their use. 11-13 The weighted marginal cost of capital (WMCC) is the firm’s weighted average cost of capital associated with its next dollar of total new financing. The WMCC is of interest to managers because it represents the current cost of funds should the firm need to go to the capital markets for new financing. The schedule of WMCC