The cost of capital is the rate of return a firm must earn on its investments in projects in order to maintain the market value of its stock
The cost of capital reflects the cost of funds over a long-run time period
The cost of capital depends on the risk-free cost of that type of funds, the business risk of the firm and the financial risk of the firm
The cost of capital is a weighted average of The cost of funds which refects the interelatioship of financing decisions
The four basic sources of long-term funds for the business firm are 1. long-term debt2. preferred stock3. retained earnings4. new common stock
A tax adjustment must be made in determening the cost of long-term debt
Debt is generally the least expensive source of capital, primarily due to the tax deductibility of interest payments
The yield to maturity is a market determined rate and can be found by examining the relationships of security price, periodic interest payments, maturity value, and length of time to maturity
Preferred stock is similar to debt in that the preferred dividen is fixed
The firm’s ability to acquire equity capital is through retained earnings or through new common stock
The cost of common stock equity may be estimated by using the Gordon model or the capital asset pricing model (CAPM)
The cost of retained earnings can be explained as an opportunity cost for the use of the stock holders’ funds
The cost of new common stock financing is higher than the cost of retained earnings due to flotation costs and underpricing
The firm’s optimal mix of debt and equity is called its target capital structure
The optimal capital structure is the one that balances return and risk factors in order to maximize market value
The before-tax cost of debt for a 15-year, 11 percent coupon rate, $1,000 par value bond selling at $950 is 15 11I/Y $1,000PV CPT PMT =11.72%
A firm has issued preferred stock at its $120 per share par value. The stock will pay a $15 annual dividened. The cost of issuing and selling the stock was $3 per share. The cost of the preferred stock is 15/(120-3) = 12.82%
A firm has common stock with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. The growth rate in dividends has been 4 percent. The cost of the firm’s common stock equity is (2/25)+.04 =12%
Capital budgeting is the process of evaluating and selectiong long-term investments consistent with the firm’s goal of owner wealth maximization
Earning assets are fixed assets that provide the basis for the firm’s profit and value
The most common motive for adding fixed assets to the firm is Expansion
Projects that compete with one another, so that the acceptance of one eliminates the others from further consideration are called Mutually exclusive projects
A firm with limited dollars available for capital expenditures is subject to capital rationing
The payback period is the exact amount of time it takes the firm to recover its initial investment
The minimum return that must be earned on a project in order to leave the firm’s value unchanged is the cost of capital
Net present Value (NPV) -is a sophisticated capital budgeting technique -found by subtracting a projects initial investment from the present value of its cash inflows discounted at a rate equal to the firm’s cost of capital
The internal rate of return (IRR) the discount rate that equates the present values of the cash inflows with the initial investment
Comparing net present value and internal rate of return analysis always results in the same accept/reject decision
On a purely theoretical basis, the NPV is the better approach to capital budgeting because it measures the benefits relative to the amount invested
In comparing the internal rate of return and net present value methods of evaluation, net present value is superior, but financial managers prefer to use internal rate of return
The profitability index (PI) is the present value of cash inflows divided by the initial cash outflow
The change in net working capital when evaluating a capital budgeting decision is the change in current assets minus the change in current liabilities
When evaluating a capital budgeting project, the change in net working capital must be considered as part of the initial investment
Sunk costs are cash outlays that had been previously made and have no effect on the cash flows relevant to a current decision
Opportunity costs cash flow that could be realized from the best alternative use of an owned asset
The book value of an asset is equal to the original purchase price minus accumulated depreciation
In the context of capital budgeting, risk refers to the degree of variablity of the cash inflows
Sensitivity analysis measures the risk of a capital budgeting project by estimating the NPVs associated with the optimistic, most likely, and pessimistic cash flow estimates
Scenario analysis is a behavioral approach that evaluates the impact on the firm’s return of simultaneous changes in a number of project variables
The risk-adjusted discount rate (RADR) reflects -the return that must be earned on the given project to compensate the firm’s owners adequately according to the project’s variability of cash flows-It is the preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint
Important types of risk in an international capital budgeting context include (2) 1. exchange rate risk2. political risk
The annualized net present value approach is used to convert the net present value of unequal-lived projects into an equivalent annual amount

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