9 The Cost of Capital ‘The cost of capital ~is an extremely important rate of return-> expected average future cost to the firm of funds over the long run. ‘The cost of capital —> minimum rate of return that a firm must earn on its investments, to grow firm value. DA weighted average cost of capital-> find the expected average future cost of funds over the long run, >The relevant cost of capital for a firm is the marginal cost of capital necessary to raise the next marginal dollar of financing to fund the firm’s future investment opportunitis. The before-tax cost of long-term debt ->Using: 1. Cost quotations, calculations 2. Approximation. 3. The after-tax cost of debt > is calculated by multiplying the before-tax cost of debt by 1 minus the tax rate. The affer-iax cost of debt is the relevant cost of debt because it is the lowest possible cost of debt for the firm due to the deductibility of interest expenses. Bxsfersdstosk> ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock. ‘Component cost stock WAGE abel -T) + abet SakeCommon stock equity, > convert it into the cost of retained earnings and the cost of new issues of common stock. The cost of common stock equity > can be calculated by using the constant-growth valuation > CAPM, WACK = solprotax §e)(1-T) + yoko + Soles Calculate the weighted average cost of capital (WAGE), - WAGE reflects the expected average future cost of funds over the long run. = Itcombines the costs of specific types of capital after weighting cach of them by its proportion. WACK ~ solpretax g)(1-Tax rate) + geckos + Soaks © The x’s referto the firm’s capital structure weights. © The k’s refer to the cost of cach component.