Learning Objectives Classes 19-22
Be able to explain the relevance of cost of capital and how it is used
Be able to explain and compute the cost of debt to a company [YTM (1-taxrate)]
Be able to compute the PV of a perpetuity.
Be able to compute the cost of preferred stock (to a company)
Be able to explain how investor expectations create a cost to the company for common equity.
Be able to explain and compute the cost of common equity (to a company) using the Capital
Asset Pricing Model (CAPM).
Be able to explain the underlying assumptions of the CAPM
Be able to interpret and compute the Weighted Average Cost of Capital (WACC)
Be able to compute and interpret the NPV of cash 1ows and be able to explain, interpret, and
compute the present value of uneven cash 1ows
Be able to represent and explain the time line for uneven cash 1ows.
Be able to compute and interpret IRR of cash 1ows
Be able to explain the relative strengths and weaknesses of NPV and IRR
Be able to explain, interpret and compute a capital budgeting case using the cost of capital and
NPV analysis
Where/How do companies get the money to make investments?
Financing of Investments (Long term assets); Comes from either Debt or Equity; Assets are
purchased by borrowing (Debt) or with Owners Investments; What are the different sources of
Debt & Equity?
Debt:
Private Debt (no SEC registration required)
Small Business Administration
Mortgages (purchase of real estate)
Lines of Credit with banks
Notes Payable (can be between two companies)
Public Debt (requires SEC registration, traded on exchanges)
Corporate Bonds: make coupon(interest) payments
Zero Coupon Bonds
Corporate Bonds
In US make semi-annual coupon payments
Have restrictive covenants to protect lenders (buyers of the bonds) ex. Must maintain minimum
cash balance
Must go through SEC registration process
Bond Indenture = name of contract between corporation and the buyers (lenders) that details
terms: coupon payments, restrictive covenants, maturity date etc.
Corporate Debt
Debenture – no collateral (unsecured debt)
Asset – backed Debt (secured debt) – in case of default, speciCc assets would be sold
Subordinate Debt – there is other debt that would receive payments/money before this debt
Reminder: debt is rated = companies ability to make payments
Equity:
Retained Earnings: Income not paid out to owners
Private: Owners, their family and friends, Angel Investors, VC, Private Equity
Public (SEC registration)
Common Stock: company no obligation to ever pay anything; considered true owners, have
voting rights for auditors and board of directors
Preferred Stock: no voting rights, company has obligation to pay dividends if and when it’s able
Weighted Average Cost of Capital
Assets = investments by management
Debt and Equity = sources of Cnancing to purchase these assets
WACC is an es#mate of
the current cost of debt and equity for a speciCc Crm
They do not want their WACC to be greater than the return on an investment
Current costs are used because
the investment is being considered NOW (currently)
MV used because
making the decision today
MV re1ects prices today
Perpetuity
This is a payment that is
