115 CFA
File: Corporate Finance - Reading 33 - 1. Cost of Capital

1. Cost of Capital

a. calculate and interpret the weighted average cost of capital (WACC) of a company;

b. describe how taxes affect the cost of capital from different capital sources;

c. describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined;

d. explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget;

e. explain the marginal cost of capital's role in determining the net present value of a project;

What is weighted average cost of capital (WACC) and what is the formula?
- The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock, and common stock or equity.
- Also referred to as marginal cost of capital (MCC)
- $$WACC = w_d r_d (1 - t) + w_p r_p + w_e r_e$$
- w_d = weight for the debt
- w_p = the weight for preferred stock
- w_e = the weight for common stock
- r = required rate for each component
- t = the marginal tax rate

How do taxes influence the cost of capital?
Interest on debt is tax deductible; therefore, to calculate the cost of debt, the tax benefit is deducted.

What is a target capital structure?
The target capital structure is the percentage of debt, preferred stock, and common equity that a firm is striving to maintain and that will maximize the firm's stock price.

What is an Investment Opportunity Schedule (IOS)?
The Investment Opportunity Schedule (IOS) is the prioritized list of capital projects, listed by IRR (internal rate of return) from highest to lowest.

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