FIN 345 1st EditionExam # 4 Study Guide Chapters: 10 and 12Chapter 10 and 121. Cost of Capitala. The firms average cost of funds, which is the average return required by the firms investorsb. What must be paid to attract fundsc. The firms required rate of return, rd. Sources of capitali. Bonds – Debtii. Equity1. Preferred stock2. Common stockiii. New stock – preferred or common2. The logic of the weighted average cost of capitala. The use of debt impacts a firms ability to use equity and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific type of financing used to fund a particular project3. Basic definitionsa. Component costs of capital: types of capital used by firms to raise moneyb. WACC: weighted average cost of capitalc. Capital structure: combo of different types of capital used by a firm4. Cost of Debta. The relevant before-tax cost of new debt (rd) is the yield to maturity (YTM) on existing bondsb. Interest payments are tax deductiblec. After-tax cost of debt, rdT 5. Cost of preferred stocka. Rate of return investors require on the firms preferred stockb. The preferred dividend divided by the net issuing price6. Cost of retained earnings (Internal equity) rsa. Based on the fact that investors demand the firm use funds that are retained toearn an appropriate rate of returnb. Rate of return investors require on the firm’s common stock should equal the stocks expected returnc. Three approaches:i. CAPMii. Discounted cash flow (DCF)iii. Bond-yield-plus-risk-premium7. Three approaches to cost of retained earningsThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.a. CAPMi. Internal equity = risk free rate of return +(market return - risk free rate of return) times beta coefficient for Stock sb. DCFi. Price and expected rate of return on a share of common stock depend on the dividends expected on the stockc. Bond-yield-plus-premiumi. Estimate a risk premium above bonds’ YTM, rdii. Judgmental estimate for premiumiii. Ballpark figure only8. Cost of newly issued common stock (external equity)a. External equityi. Based on the cost of retained earningsii. Adjusted for flotation costs (the expenses of selling new issues), F (stated in decimal form)9. Target capital structurea. Optimal capital structurei. Percentage of debt, preferred stock, and common equity that will maximize the price of the firms stock10. Weighted average cost of capital (WACC)a. WACC: i. A weighted average of the component costs of debt, preferred stock, and common equity11. Marginal cost of capitala. MCC:i. The cost of obtaining another dollar of new capitalii. The weighted average cost of the last dollar of new capital raisedb. MCC Schedulei. Marginal cost of capital schedule: a graph that relates the firm’s weighted average of each dollar of capital to the total amount of new capital raisedii. Reflects changing costs depending on amounts of capital raisediii.12. Break Pointa. BP:i. The dollar value of new capital that can be raised before an increase in the firm’s weighted average cost of capital occursii. Break point= max amount of lower cost of capital given type divided by the proportion of this type of capital in the capital structureiii. Break points depend on capital structure used1. Combining the MCC and investment opportunity schedulesa. Use the MCC schedule to find the appropriate cost of capital for determining whether a project should be purchasedb. Investment opportunity schedule (IOS)i. Graph of the firms investment opportunities ranked in order of the projects rate of return2. WACC versus required rates of returna. Debt, preferred stock, or common equity (stock)1. Key Informationa. When we refer to a firms capital, we generally mean the sources of long-term funds that are used to purchase plant and equipmenti. Long-term funds are classified as:1. Debt-the firms bond issues2. Equity-the firms stock issuesb. The component costs of capital (the cost of debt and the costs of preferred and common equity) are computed by determining the return that the firm must pay to shareholders to attract their fundsc. What is the WACC? How is it used to make informed financial decisions?i. To make appropriate investment decisions the firm must know its WACCii. To determine its required rate of return, the firm must compute the costof each source of funds or capital that investors provideiii. These costs are then combined by weighting each component by the proportion or weight that it contributes to the total capital of the firm; the result is the weighted average cost of capital or WACC which is the firms required rate of returnd. How is the MCC used to make investment decisions?i. The firm should invest until the marginal cost of capital equals the rate of return on the last project that is purchasedii. As long as the investments expected return exceeds the firms WACC the investment should be