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MK R Summary CH 14&16 Vania Salma Hermayanti 2206068192

The document discusses the cost of capital and capital structure. It defines the cost of capital as depending on how funds will be used, not the source. It also defines the costs of equity, debt, and preferred stock. The weighted average cost of capital (WACC) weights the costs of each based on the capital structure. The effect of financial leverage on returns and risk is discussed. The document also summarizes M&M propositions which state that the value of the firm is independent of capital structure, but the cost of equity is a positive linear function of capital structure. Taxes are also mentioned as impacting WACC.

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39 views5 pages

MK R Summary CH 14&16 Vania Salma Hermayanti 2206068192

The document discusses the cost of capital and capital structure. It defines the cost of capital as depending on how funds will be used, not the source. It also defines the costs of equity, debt, and preferred stock. The weighted average cost of capital (WACC) weights the costs of each based on the capital structure. The effect of financial leverage on returns and risk is discussed. The document also summarizes M&M propositions which state that the value of the firm is independent of capital structure, but the cost of equity is a positive linear function of capital structure. Taxes are also mentioned as impacting WACC.

Uploaded by

vaniasalma23
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CH 14 Cost of Capital

● The Cost Capital


The cost of capital depends primarily on the use of the funds, not the source
● The cost of equity : the return that equity investors require on their investment in the firm
- The divide growth model approach

Advantage : simplicity; easy to understand


Disadvantage : useless in many cases; estimated cost of equity is very sensitive
to the estimated growth rate.
- The SML approach
Depends on the risk-free rate (Rf), the market risk premium (E(Rm)-Rf), and the
systematic risk of the asset relative to the average (betas)

● The costs of debt and preferred stock


- The cost of debt : the return that lenders require on the firm’s debt
- The cost of preferred stock

● The weighted average cost of capital


- The capital structure weights

- Taxes and the weighted average cost of capital


WACC : The weighted average of the cost of equity and the aftertax cost of debt
● Divisional and project costs of capital

● Company valuation with the WACC


● Floatation costs and the average cost of capital
- The basic approach

- Floatation costs and NPV


- Internal equity and flotation costs

CH 16 : Financial Leverage and Capital Structure Policy

● The effect of financial leverage


● Corporate borrowing and homemade leverage
- Homemade leverage : the use of personal borrowing to change the overall
amount of financial leverage to which the individual is exposed.
- The effect of financial leverage depends on the company’s EBIT
- Under the expected scenario, leverage increases the returns to shareholders, as
measured by both ROE and EPS
- Shareholders are exposed to more risk under the proposed capital structure
because the EPS and ROE are much more sensitive to changes in EBIT
- Because of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock, capital structure is an important
consideration
● Capital structure & the cost of equity capital
- M&M Proposition I : the proposition that the value of the firm is independent of
the firm’s capital structure.

- M&M Proposition II : the proposition that a firm’s cost of equity capital is a


positive linear function of the firm’s capital structure.

● Business risk : the equity that comes from the nature of the firm’s operating activities
● Financial risk : the equity risk that comes from the financial policy (the capital structure)
of the firm
● M&M propositions I and II with corporate taxes

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