# Risk Free Interest Rate

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CHAPTER 12: COST OF CAPITAL A. OVERVIEW Definition: Cost of capital refers to the rate of return • a firm must earn on its investment projects to increase the market value of its common shares • required by market suppliers of capital to attract funds to the firm Notes: • If project rate of return > cost of capital ( value of firm increases • If project rate of return < cost of capital ( value of firm decreases • Goal: minimize cost of capital Assumptions: 1. Business risk (not able to cover operating costs) is unchanged 2. Financial risk (not able to cover financial obligations) is unchanged 3. Cost of capital is measured on an after-tax basis Basic equation: Ways to evaluate the basic…show more content…
• Keep weights in decimals; keep cost in %. • Should we use kr or kn? – Kr is often less costly than Kn ( retained investment is often used first for long-term financing. • How to find weights? – Book value weights: use accounting values to measure the proportion – Market value weights: use market values (prices) to measure the proportion (preferred) – Historic weights: book/market value weights based on actual capital structure proportion – Target weights: book/market value weights based on desired capital structure Example A firm has on its books the amounts and specific (after-tax) costs shown in the following table. Find WACC. |Source |Book value |Specific cost | |Long-term debt |\$700,000 |5.3% | |Preferred equity |50,000 |12.0 | |Common equity |650,000 |16.0 | 1. The text book uses slightly different notations: G. Final Notes 1. Relative risks and costs; not absolute 2. Changes in capital structure may affect • The weights in calculating WACC • The relative risks and, therefore, return on equity (and the cost of debt) 3. Combine with CAPM to assess changes in capital structures and the beta • Example Suppose a