Lecture 2

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Lecture 2

© All Rights Reserved

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The cost of capital concept

and ordinary shares

Investors expect a higher return for a higher level of risk (example

ordinary shares) and lower required return for lower levels of risks

(example secured debts).

Each source of finance will involve different costs. The cost of

capital is therefore expressed as a weighted average that reflects

the costs of permanent sources of financing.

Therefore, the cost of capital is the minimum rate of return on

the firms investments that will compensate the suppliers of

capital to the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 2

The cost of capital concept

Some investment projects may be funded, for example, by a new

issue of equity and at first glance we might think that the cost of

capital for that investment is the investors required return on the

new share issue.

However, a company usually consists of a collection of projects

and the investors participating in a new share made to finance a

particular project participate in the profit generated by all existing

and future projects of the company, not just the project the new

issue will be used to fund.

This means that the cost of a particular source of finance for an

investment made by the company does not tell the entire cost of

capital story.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 3

The cost of capital concept

The company needs to be able to generate sufficient return to

meet the claims of all providers of finance and still have enough

to cover the required return of ordinary shareholders.

If the company can earn more than the minimum rate of return

on the firms investments that will compensate the suppliers of

capital to the firm, the share price should increase.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 4

The cost of capital concept

Determinants of the cost of capital

contributes to its total cost of funds.

The requirement for regular interest payments and the legal

provisions that allow creditors to call for the winding up of a

business mean that those supplying debt capital face the least

risk.

Therefore, we can expect creditors to have a relatively low

required return.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 5

The cost of capital concept

Determinants of the cost of capital

shareholders. We expect that the required return on this source of

funds would be higher than debt, but lower than that for ordinary

shares.

As ordinary shareholders are the residual claimants, and therefore

have the riskiest cash flows from their investments, we expect

that theyll have the highest required rate of return.

The required rate of return for preference shareholders will fall in

between that of the creditors and the ordinary shareholders.

Hence, we can conclude that the risk for each source of capital

drives the investors required returns.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 6

The cost of capital concept

Determinants of the cost of capital

of each component (or source) of finance.

For example, assume a firm is financed using 50% debt and

50% equity. Assuming the cost of debt is 8% and the cost of

shares is 14%, the cost of capital would be 11% (0.5*8 +

0.5*14).

If the proposed project returns the cost of capital, the firms value

will remain unchanged. If the proposed project returns more than

the cost of capital, the value of the firm should increase.

Alternatively, if the proposed project returns less than the cost of

capital, the value of the firm would decrease.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 7

The cost of capital concept

Taxation regimes and the cost of capital

country as the company paying the dividends.

Foreign shareholders live (and pay tax) in a different

country from that of the company paying the

dividends.

Franked Dividend: a dividend carrying and attached

franking or tax credit.

Fully Franked Dividend: a dividend that carries a tax

credit equal to the full percentage of company tax paid

on the underlying profit.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 8

The cost of capital concept

Taxation regimes and the cost of capital

shareholders and profit distributed as dividends is

taxed only at the shareholders personal tax rate.

In this case, none of the imputation credits distributed

by the company are lost and corporate taxes are not

relevant in the determination of the cost of capital.

For fully integrated companies, the component costs

should be calculated on a before-tax basis.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 9

The cost of capital concept

Taxation regimes and the cost of capital

integrated into the dividend imputation tax system, as

any available franking credits are not passed on to

shareholders.

Foreign shareholders may gain no benefit from

receiving fully franked dividends.

For both companies that pay no dividends and foreign

shareholders, as well as business structured as sole

traders and partnerships, the after-tax cost of capital

is relevant.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 10

Estimating the component costs

Finding the margin cost of funds

Issues costs are the costs associated with bringing an

issue of securities to the market. Also known as

floatation costs for equity issues.

These costs include any underwriting fees and costs for

preparing a prospectus, in addition to costs associated

with the advertising and promotion of the issue.

It may be necessary for the firm to issue new equity

securities at an offer price lower than the current

market price to ensure sufficient funds are raised from

the issue. This discount is also considered a cost.

Issue costs are often stated as a percentage of the issue

price.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 11

The cost of capital concept

Determinants of the cost of capital

from investors minus any costs associated with the

issue.

The marginal cost of a particular source of capital is

the cost associated with raising the next dollar from

that source.

The historic cost of funds raised is irrelevant when

comparing how much a new project would have to

earn to satisfy the suppliers of capital.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 12

Estimating the component costs

Finding the margin cost of funds

Equation 7.1 shows the relationship between net proceeds and

issue costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 13

Estimating the component costs

Calculating net proceeds of an issue

Keating Ltd is planning the issue of 1 million ordinary shares. The

shares will be offered to the market at $5 each. The investment

bank handling the issue has agreed to bear all the costs of the

issue for a fee of 4.6% of total funds raised. What net proceeds per

share can Keating expect and what would be the total net proceeds

from this issue?

NP = 5(1-0.046)

NP = $4.77

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 14

Estimating the component costs

Cost of debt

generated in order to meet the required return of debt-

holders.

To estimate the cost of debt, one needs to find the required

return of debt holders.

The cost of previous issues is not relevant when we use the

cost of capital as a yardstick for assessing new projects.

Therefore, we measure the marginal cost of debt or the cost

associated with a new issue.

For ease of computation, we use zero coupon bonds

initially to calculate the cost of debt.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 15

Estimating the component costs

Cost of debt

zero coupon valuation equation gives:

Solving equation 7.2 for rb will give us the before tax cost of

debt, denoted kz,bt.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 16

Estimating the component costs

Cost of debt

need to find the discount rate that makes the PV of the

future cash flows equal to the net proceeds of the

bond. This discount rate is also called the internal

rate of return (IRR).

Interpolation is the process of approximating an

unknown return using trial and error.

The interpolation method is easiest to implement

using the IRR function embedded within a financial

calculator or a spreadsheet package such as Excel.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 17

Estimating the component costs

Cost of debt

discount rate that will make the present value of the future

cash flows equal to the net proceeds of the bond. The same

process continues until you get one discount rate that gives

the nearest calculated price just above the net proceeds and

the next discount rate above that one gives a calculated price

just below the net proceeds.

The next step is to estimate where between our two discount

rates the cost of debt lies.

The whole process is demonstrated in the following

example:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 18

Estimating the component costs

A zero coupon bond has a face value of $100,000 and 3 years to

maturity. Interest accrues on the bond annually. The net proceeds

of the bond are $90,000. What is the cost to the company of this

source of finance?

= 100 000/(1+kz,bt)3

= 100000/(1+0.05)3

= $86 385.63

(note: there is an inverse relationship between the discount rate and

the value of security. The higher the discount rate the lower the value

of security and vice versa.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 19

Estimating the component costs

So we choose a lower discount rate. Try 4%.

NP= 100000/(1+0.04)3

= $88 896.79

So we choose a lower discount rate. Try 3%.

NP= 100000/(1+0.03)3

= $91 516.43

and as the next whole percentage was too low, we can tell that

the cost of debt is between 3% and 4%.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 20

Estimating the component costs

So we take the interpolation between 3% and 4% as:

Difference of lower discount rate value and net

proceeds 91 516.43 90 000 = 1516.43

Difference of lower and higher discount rate value

91 516.43 88 896.79 = 2619.64

Take ratio of difference 1516.43/2619.64 = 0.5789

Lower rate ratio 3% +0.5789 = 3.58%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 21

Estimating the component costs

Cost of debt

tedious way to approximate the cost of debt is to use

equation 7.3:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 22

Estimating the component costs

Before- tax cost of zero coupon bonds

Using the previous example: A zero coupon bond has a face value

of $100,000 and 3 years to maturity. Interest accrues on the bond

annually. The net proceeds of the bond are $90,000. What is the

cost to the company of this source of finance?

(100 000+90 000)/2

= 3333.33/95 000

= 0.35088 or 3.51%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 23

Estimating the component costs

Before- tax cost of zero coupon bonds

This is a little different from the 3.58% we estimated

using the trial and error method. The difference is

attributable to the methods we used to approximate.

This method is less accurate than the previous method.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 24

Estimating the component costs

Before tax cost of coupon bonds

Coupon bonds have more cash flows than zero coupon bonds,

further complicating the estimation of the cost of debt. Thus the

following equation (7.4) is used:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 25

Estimating the component costs

Before tax cost of coupon bonds

Again, to find the required return or cost of debt, we

need to find the discount rate that makes the PV of the

future cash flows equal to the net proceeds of the

bond. This discount rate is also called the internal

rate of return (IRR).

The most efficient way to do this is by using the IRR

function in a spreadsheet or a financial calculator

Without access to a computer or a financial calculator,

the cost of debt on coupon bonds is approximated

using the trial and error (interpolation) method as

shown in the following example:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 26

Estimating the component costs

Before tax cost of coupon bonds

A bond has a face value of $100,000 and three years to

maturity. The coupon rate is 5% and coupon are paid

annually. The next coupon is due in 12 months time and the

issue will generate net proceeds of $90,000. what is the cost

to the company of this source of finance?

5000/(1.09)1 +5000/(1.09)2 +5000+100 000/(1.09)3

= $89 876.64

Try 8% as a first pass at the cost of debt

5000/(1.08)1 +5000/(1.08)2 +5000+100 000/(1.08)3

= $92 269.50

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 27

Estimating the component costs

Before tax cost of coupon bonds

We can tell from the calculation that a cost of 9% is too high and the

cost of 8% is too low. So we interpolate between these two rates to

get a better estimate of the cost of debt as shown:

Difference of lower discount rate value and net proceeds

92 269.50 90 000 = 2269.50

Difference of lower and higher discount rate value

92 269.50 89 876.64 = 2392.86

Take ratio of difference 2269.50/2392.86 = 0.9484

Lower rate ratio 8% +0.9484= 8.95%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 28

Estimating the component costs

Before tax cost of coupon bonds

The previous use of interpolation method was fairly simple

because there were cash flows for only three periods, however this

becomes difficult with longer terms. As such the following formula

(Equation 7.3) could be applied

The coupon rate is 5% and coupon are paid annually. The next

coupon is due in 12 months time and the issue will generate net

proceeds of $90,000. what is the cost to the company of this source

of finance?

5000 + (100 000 90 000)/3

(100 000 +90 000)/2

= 0.087719 or 8.77%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 29

Estimating the component costs

Cost of debt

before-tax basis.

When imputation credits are not available, maximising owners

wealth is achieved by maximising the after-tax return to owners.

We convert the before-tax cost of debt to an after tax cost of debt

using the following equation 7.5:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 30

Estimating the component costs

Cost of preference shares

must be generated in order to meet the required return of

preference shareholders.

Substituting the net proceeds for the intrinsic value in the

preference share valuation equation and rearranging gives

equation 7.6 which is the cost of preference shares:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 31

Cost of Preference Shares

After-tax cost of preference shares

Legolas Ltd is planning the issue of preference shares at

an offer price of $100 per share. Dividend payments of

$5.35 will be made annually. Floatation costs are

estimated at 3.5% of offer price. What is the after-tax

cost of preference shares for Legolas?

where

= 5.35/(100(1-0.035)

=5.35/96.50

= 0.05544 or 5.54%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 32

Estimating the component costs

Cost of preference shares

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 33

Continued

Before-tax cost of preference shares

Given a corporate tax rate of 30% and the information

about the Legolas Ltd preference shares issue in

previous example, calculate the before-tax cost of

preference shares.

= 5.35/(1-0.30)

96.50

=7.64/96.50

= 0.0792 or 7.92%

The before-tax value of Legolass dividend consists of the cash

payment of $5.35 plus imputation credits of $2.29, giving a before tax

value of $7.64. the before tax cost of preference shares is 7.92%.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 34

Estimating the component costs

Cost of ordinary equity

The cost of ordinary equity is the level of return that must

be generated in order to meet the required return of the

ordinary shareholders.

The ultimate purpose of company earnings is to be paid as

dividends or to be reinvested in the company on the

shareholders behalf.

Retained earnings represent the accumulated profit of the

company that has not been paid out to shareholders as

dividends.

Retained earnings are not a free source of funds for new

projects.

Retained earnings belong to the ordinary shareholders and

the ordinary shareholders expect to get their required return

on this source of funds.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 35

Estimating the component costs

Cost of ordinary equity

After tax Cost of retained earnings

The cost of retained earnings is the required return of ordinary

shareholders on shares that have already been issued.

Assuming that the constant growth assumption is applicable to

the company in question, we can rearrange the constant growth

model to obtain the cost of retained earnings As in equation 7.8:

where: Dt = D0 (1 + g)t

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 36

Cost of Ordinary equity cost of retained earnings

After-tax cost of retained earnings

The ordinary shares of Legolas Ltd are currently

trading at $4.72. A dividend of 50c was recently paid and

the next dividend is due a year from now. The

estimated growth rate is 4% per annum. What is the

after-tax cost of retained earnings for Legolas?

;where: Dt = D0 (1 + g)t

= 0.50(1+0.04)/4.72 +0.04

= 0.52/4.72 + 0.04

= 0.150169 or 15.02%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 37

Estimating the component costs

Cost of ordinary equity

Before tax Cost of retained earnings

The before-tax cost of retained earnings for a company that

pays a fully franked dividend uses the grossed up dividend

amount. Equation 7.9 gives this cost:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 38

Continued

Before-tax cost of retained earnings

If the corporate tax rate is 30% and Legolas pays fully

franked dividends, what is the before-tax cost of

retained earnings?

= 0.50(1+0.04)/(1-0.30) + 0.04

4.72

= 0.52/0.7 + 0.04

4.72

= 0.1974 or 19.74%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 39

Estimating the component costs

Cost of new share issues

The cost of ordinary shares is the required return of

shareholders on a new issue.

The main difference between estimating the cost of new

ordinary shares and retained earnings is the use of net

proceeds rather than current market price.

The formula for calculating the after tax cost of ordinary

shares is given by equation 7.10:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 40

Cost of new share issues

trading at $4.72. A new share issue would be made at an

offer price of $4.70. Issue costs are expected to be 3% of

the proceeds of the issue. The last dividend was 50c and

the next dividend is due a year from now. The

estimated growth rate is 4% per annum. What is

Legolas after-tax cost of an ordinary share issue?

= 0.50(1+0.04) + 0.04

4.70(1-0.03)

= 0.52/4.56 + 0.04

= 0.15404 or 15.4%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 41

Estimating the component costs

Cost of ordinary equity

Cost of new share issues

To obtain the before-tax cost of a new issue we gross up the

dividend to reflect the 100% franking credits. The equation

for the before-tax cost of a new issue is (7.11):

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 42

continued

Before-tax cost of new share issue

corporate rate is 30%, what is the before-tax cost of a

new issue of ordinary shares?

4.56

= 0.1629+0.04

= 0.2029 or 20.30%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 43

Estimating the component costs

Cost of ordinary equity

Cost of new share issues

We can use the CAPM as an alternative to the dividend

discount model to calculate the cost of ordinary shares.

The after-tax cost of ordinary shares is given by equation

7.12:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 44

CAPM and the after-tax costs of ordinary shares

rate is 5.5% and the equity risk premium (ERP) is

5%. What is the after-tax cost for the ordinary

shares of Arwyn?

= 0.055+1.6(0.05)

= 0.135 or 13.5%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 45

Estimating the component costs

Cost of ordinary equity

Cost of new share issues

While the CAPM does not require forecasts of

dividends or assumptions about a dividend growth

rate, it does need a forecast of the equity risk premium,

E(RM)-Rf, a measure of the risk-free rate, Rf, and a

measure of systematic risk, , of the firm.

Another complication with applying the CAPM to

calculate the cost of ordinary shares is that the model

does not incorporate floatation costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 46

The weighted-average cost of capital

sum of each component cost of capital weighted by

each component costs proportion of the firms capital

structure.

When we assess a project to determine its impact on

the value of the firm, we need to take a wider view

than determining if the project is expected to return

more than the component cost of finance that would

be used to fund the project.

Equation 7.13 shows how the weighted cost of capital is

derived from the component costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 47

The weighted-average cost of capital

proportion, Wx, that kx represents in the firms capital structure.

proportion that each component represents in the firms capital

structure in order to determine the WACC.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 48

The weighted-average cost of capital

Example

The financial manager of Exa-Life has identified the amount of

funds attributable to each component of the cost of capital and the

amount derived from each source of funds as follows:

Source of Funds Component Amount of

costs(kx) Financing

Term loans 0.067 2 000 000

Bonds 0.081 20 000 000

Preference Shares 0.085 10 000 000

Ordinary Shares 0.125 50 000 000

step is to determine the weights, Wx. To do this we total the amount

derived from each source of funds and divide the amount

attributable to each component by the total funding amount.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 49

The weighted-average cost of capital

Example contd

Source of Funds Amount of Proportion of total funding (Wx)

Financing

Term loans 2 000 000 2 000 000/82 000 000 = 0.0244

Bonds 20 000 000 20 000 000/82 000 000 = 0.244

Preference Shares 10 000 000 10 000 000/82 000 000 = 0.122

Ordinary Shares 50 000 000 50 000 000/82 000 000 = 0.61

82 000 000 1.00

Source of Funds Component Proportion(Wx) Weighted

costs(kx) cost(kx x Wx)

Term loans 0.067 0.0244 0.0016

WACC 0.108

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 50

The weighted-average cost of capital

As an alternative to the table, the WACC can be calculated

using the following equation directly as follows:

= 0.0016+0.0198+0.0104+0.0763

= 10.8%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 51

The weighted-average cost of capital

Alternatives for weighting

capital to obtain the WACC are book value weights and target

weights.

The book value weighting method bases the weights on the firms

current balance sheet. This results in a weighting scheme that

reflects how the firm has been financed in the past.

However, the book values shown in the balance sheet do not

reflect the current value of the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 52

The weighted-average cost of capital

Alternatives for weighting

worth.

Current market values are more relevant to decisions

that will impact on future market value.

A better weighting alternative is to use target weights

(based on market values) for each source of funding.

Target weights are based on managements future plans

for financing the companys operations.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 53

54

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