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Cost of Capital. Chapter 12. Required Rates on Projects. An important part of capital budgeting is setting the required rate for the individual project. Required Rates on Projects. An important part of capital budgeting is setting the required rate for the individual project.

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Cost of capital

Cost of Capital

Chapter 12


Required rates on projects

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project


Required rates on projects1

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100


Required rates on projects2

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100

1,100

(1+ .09)

If Required Rate = 9%:

NPV = -1,000 +

= $9.17


Required rates on projects3

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100

1,100

(1+ .09)

If Required Rate = 9%:

NPV = -1,000 +

= $9.17

Accept Project since NPV > 0


Required rates on projects4

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100

1,100

(1+ .09)

If Required Rate = 9%:

NPV = -1,000 +

= $9.17

Accept Project since NPV > 0

1,100

(1+ .11)

If Required Rate = 11%:

NPV = -1,000 +

= –$9.01


Required rates on projects5

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100

1,100

(1+ .09)

If Required Rate = 9%:

NPV = -1,000 +

= $9.17

Accept Project since NPV > 0

1,100

(1+ .11)

If Required Rate = 11%:

NPV = -1,000 +

= –$9.01

Reject Project since NPV < 0


Required rates on projects6

Required Rates on Projects

  • An important part of capital budgeting is setting the required rate for the individual project

Example: Consider the following project

0 1

-1,000

+1,100

1,100

(1+ .09)

If Required Rate = 9%:

NPV = -1,000 +

= $9.17

Accept Project since NPV > 0

1,100

(1+ .11)

If Required Rate = 11%:

NPV = -1,000 +

= –$9.01

In order to estimate correct required rate, companies must find their own unique cost of raising capital


Factors affecting cost of capital

Factors Affecting Cost of Capital

  • General Economic Conditions--inflation, investment opportunities

    • Affect interest rates

  • The Following Factors affect risk premium

  • Market Conditions

  • Operating and Financing Decisions

    • Affect business risk

    • Affect financial risk

  • Amount of Financing

    • Affect flotation costs and market price of security


Model assumptions

Model Assumptions

Weighted Average Cost of Capital Model

  • Here, we determine the average cost of capital of a firm by assuming that the firm continues with its business, financing and dividend policies.


Computing weighted cost of capital

Computing Weighted Cost of Capital

Weighted Average Cost of Capital (WACC)

  • Average cost of capital of the firm.

  • To find WACC

  • 1. Compute the cost of each source of capital

  • 2. Determine percentage of each source of capital

  • 3. Calculate Weighted Average Cost of Capital


Computing cost of each source

Computing Cost of Each Source

1. Compute Cost of Debt

  • Required rate of return for creditors

  • Same cost found in Chapter 7 as “required rate for debtholders (kd) = YTM”


Computing cost of each source1

$M

(1+kd)n

Computing Cost of Each Source

1. Compute Cost of Debt

  • Required rate of return for creditors

  • Same cost found in Chapter 7 as “required rate for debtholders (kd)”

P0 =

+

where:

It =Dollar Interest Payment

Po=Market Price of Debt

M =Maturity Value of Debt


Computing cost of each source2

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?


Computing cost of each source3

$M

(1+kd)n

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

P0 =

+


Computing cost of each source4

$M

(1+kd)n

$1,000

(1+kd)10

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

P0 =

+

+

938.55 =


Computing cost of each source5

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

The before tax cost of debt is 10%

Interest is tax deductible


Computing cost of each source6

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

The before tax cost of debt is 10%

Interest is tax deductible

Marginal Tax Rate = 40%

After tax cost of bonds = kd(1 - T)


Computing cost of each source7

Computing Cost of Each Source

1. Compute Cost of Debt

  • Example

    Investors are willing to pay $985 for a bond that pays $90 a year for 10 years. Fees for issuing the bonds bring the net price (NP0) down to $938.55. What is the before tax cost of debt?

The before tax cost of debt is 10%

Interest is tax deductible

Marginal Tax Rate = 40%

After tax cost of bonds = kd(1 - T)

= 10.0%(1– 0.40) = 6 %


Computing cost of each source8

Computing Cost of Each Source

2. Compute Cost Preferred Stock

Cost to raise a dollar of preferred stock.


Computing cost of each source9

Computing Cost of Each Source

2. Compute Cost Preferred Stock

Cost to raise a dollar of preferred stock.

From Chapter 8:

Dividend (D)

Market Price (P0)

Required rate kps =


Computing cost of each source10

Computing Cost of Each Source

2. Compute Cost Preferred Stock

Cost to raise a dollar of preferred stock.

From Chapter 8:

Dividend (D)

Market Price (P0)

Required rate kps =

However, there are floatation costs of issuing preferred stock:


Computing cost of each source11

Computing Cost of Each Source

2. Compute Cost Preferred Stock

Cost to raise a dollar of preferred stock.

From Chapter 8:

Dividend (D)

Market Price (P0)

Required rate kps =

However, there are floatation costs of issuing preferred stock:

Cost of Preferred Stock with floatation costs

Dividend (D)

Net Price (NP0)

kps =


Computing cost of each source12

Computing Cost of Each Source

2. Compute Cost Preferred Stock

  • Example

    Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.


Computing cost of each source13

Computing Cost of Each Source

2. Compute Cost Preferred Stock

  • Example

    Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

Cost of Preferred Stock

$5.00

$42.00

kps =


Computing cost of each source14

Computing Cost of Each Source

2. Compute Cost Preferred Stock

  • Example

    Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

Cost of Preferred Stock

$5.00

$42.00

kps =

= 11.90%


Computing cost of each source15

Computing Cost of Each Source

2. Compute Cost Preferred Stock

  • Example

    Your company can issue preferred stock for a price of $45, but it only receives $42 after floatation costs. The preferred stock pays a $5 dividend.

Cost of Preferred Stock

$5.00

$42.00

kps =

= 11.90%

No adjustment is made for taxes as dividends are not tax deductible.


Computing cost of each source16

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Two kinds of Common Equity

    • Retained Earnings (internal common equity)

    • Issuing new shares of common stock


Computing cost of each source17

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.


Computing cost of each source18

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.

    • Cost of Internal Equity = opportunity cost of common stockholders’ funds.


Computing cost of each source19

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.

    • Cost of Internal Equity = opportunity cost of common stockholders’ funds.

    • Cost of internal equity must equal common stockholders’ required rate of return.


Computing cost of each source20

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Management should retain earnings only if they earn as much as stockholder’s next best investment opportunity.

    • Cost of Internal Equity = opportunity cost of common stockholders’ funds.

    • Cost of internal equity must equal common stockholders’ required rate of return.

    • Three methods to determine

      • Dividend Growth Model

      • Capital Asset Pricing Model

      • Risk Premium Model


Computing cost of each source21

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)


Computing cost of each source22

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model

D1

P0

kcs =

+ g


Computing cost of each source23

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model

D1

P0

kcs =

+ g

  • Example

    • The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.


Computing cost of each source24

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model

D1

P0

kcs =

+ g

  • Example

    • The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10)

60

kcs =

+ .10


Computing cost of each source25

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model

D1

P0

kcs =

+ g

  • Example

    • The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10)

60

kcs =

+ .10

= .155 = 15.5%


Computing cost of each source26

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Dividend Growth Model

      • Assume constant growth in dividends (Chap. 8)

Cost of internal equity--dividend growth model

D1

P0

kcs =

+ g

  • Example

    • The market price of a share of common stock is $60. The dividend just paid is $3, and the expected growth rate is 10%.

3(1+0.10)

60

kcs =

+ .10

= .155 = 15.5%

The main limitation in this method is estimating growth accurately.


Computing cost of each source27

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Capital Asset Pricing Model

      • Estimate the cost of equity from the CAPM (Chap. 6)


Computing cost of each source28

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Capital Asset Pricing Model

      • Estimate the cost of equity from the CAPM (Chap. 6)

Cost of internal equity--CAPM

krf + b(km – krf)

kcs =


Computing cost of each source29

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Capital Asset Pricing Model

      • Estimate the cost of equity from the CAPM (Chap. 6)

Cost of internal equity--CAPM

krf + b(km – krf)

kcs =

  • Example

    • The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.


Computing cost of each source30

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Capital Asset Pricing Model

      • Estimate the cost of equity from the CAPM (Chap. 6)

Cost of internal equity--CAPM

krf + b(km – krf)

kcs =

  • Example

    • The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

5% + 1.2(13% – 5%)

kcs =


Computing cost of each source31

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Capital Asset Pricing Model

      • Estimate the cost of equity from the CAPM (Chap. 6)

Cost of internal equity--CAPM

krf + b(km – krf)

kcs =

  • Example

    • The estimated Beta of a stock is 1.2. The risk-free rate is 5% and the expected market return is 13%.

5% + 1.2(13% – 5%)

kcs =

= 14.6%


Computing cost of each source32

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Risk Premium Approach

      • Adds a risk premium to the bondholder’s required rate of return.


Computing cost of each source33

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Risk Premium Approach

      • Adds a risk premium to the bondholder’s required rate of return.

Cost of internal equity--Risk Premium

Where:

RPc = Common stock risk premium

kd + RPc

kcs =


Computing cost of each source34

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Risk Premium Approach

      • Adds a risk premium to the bondholder’s required rate of return.

Cost of internal equity--Risk Premium

Where:

RPc = Common stock risk premium

kd + RPc

kcs =

  • Example

    • If the risk premium is 5% and kd is 10%


Computing cost of each source35

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Risk Premium Approach

      • Adds a risk premium to the bondholder’s required rate of return.

Cost of internal equity--Risk Premium

Where:

RPc = Common stock risk premium

kd + RPc

kcs =

  • Example

    • If the risk premium is 5% and kd is 10%

10% + 5%

kcs =


Computing cost of each source36

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of Internal Common Equity

    • Risk Premium Approach

      • Adds a risk premium to the bondholder’s required rate of return.

Cost of internal equity--Risk Premium

Where:

RPc = Common stock risk premium

kd + RPc

kcs =

  • Example

    • If the risk premium is 5% and kd is 10%

10% + 5%

kcs =

= 15%


Computing cost of each source37

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

    • If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.


Computing cost of each source38

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

    • If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.

    • Dividend Growth Model--Must adjust for floatation costs of the new common shares.


Computing cost of each source39

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

    • If retained earnings cannot provide all the equity capital that is needed, firms may issue new shares of common stock.

    • Dividend Growth Model--must adjust for floatation costs of the new common shares.

Cost of new common stock

D1

NP0

kcs =

+ g


Computing cost of each source40

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

Cost of new common stock

D1

NP0

knc =

+ g


Computing cost of each source41

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

Cost of new common stock

D1

NP0

knc =

+ g

  • Example

    • Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.


Computing cost of each source42

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

Cost of new common stock

D1

NP0

knc =

+ g

  • Example

    • Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

Floatation

Costs


Computing cost of each source43

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

Cost of new common stock

D1

NP0

knc =

+ g

  • Example

    • Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

3(1+0.10)

52.80

kcs =

+ .10


Computing cost of each source44

Computing Cost of Each Source

3. Compute Cost of Common Equity

  • Cost of New Common Stock

Cost of new common stock

D1

NP0

knc =

+ g

  • Example

    • Using the above example. Common stock price is currently $60. If additional shares are issued floatation costs will be 12%. D0 = $3.00 and estimated growth is 10%.

NP0 = $60.00 – (.12x 60) = $52.80

3(1+0.10)

52.80

kcs =

+ .10

= .1625 = 16.25%


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Weights of each source should reflect expected financing mix

Assume a stable financial mix–so use Balance Sheet percentages to calculate the weighted average cost of capital.


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Balance Sheet Green Apple Company

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds4,000

Total Assets$12,000Preferred Stock1,000

Common Stock5,000

Total Liabilities and

Owners Equity$12,000

Firm Raises $10,000 of capital from long term sources


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Balance Sheet Green Apple Company

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds4,000

Total Assets$12,000Preferred Stock1,000

Common Stock5,000

Total Liabilities and

Owners Equity$12,000

Compute Firm’s Capital Structure (% of each source)

Amount of Bonds

4,000

10,000

= 40%

Bonds:

Total Capital Sources


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Balance Sheet Green Apple Company

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds4,000

Total Assets$12,000Preferred Stock1,000

Common Stock5,000

Total Liabilities and

Owners Equity$12,000

Compute Firm’s Capital Structure (% of each source)

Amount of Preferred Stock

1,000

10,000

= 10%

Preferred Stock:

Total Capital Sources


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Balance Sheet Green Apple Company

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds4,000

Total Assets$12,000Preferred Stock1,000

Common Stock5,000

Total Liabilities and

Owners Equity$12,000

Compute Firm’s Capital Structure (% of each source)

Amount of Common Stock

5,000

10,000

= 50%

Common Stock:

Total Capital Sources


Cost of capital

Capital Structure Weights

Long Term Liabilities and Equity

Balance Sheet Green Apple Company

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds4,000

Total Assets$12,000Preferred Stock1,000

Common Stock5,000

Total Liabilities and

Owners Equity$12,000

40%

10%

50%

When money is raised for capital projects, approximately 40% of the money comes from selling bonds, 10% comes from selling preferred stock and 50% comes from retaining earnings or selling common stock


Cost of capital

Computing WACC

Green Apple Company estimates the following costs for each component in its capital structure:

Source of Capital Cost

Bondskd = 10%

Preferred Stockkps = 11.9%

Common Stock

Retained Earningskcs = 15%

New Sharesknc = 16.25%

Green Apple’s tax rate is 40%


Cost of capital

Computing WACC

  • If using retained earnings to finance the common stock portion the capital structure

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock


Cost of capital

Computing WACC - using Retained Earnings

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (9%)4,000

Total Assets$12,000Preferred Stock (10%)1,000

Common Stock(13%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

40%

10%

50%

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock


Cost of capital

Computing WACC - using Retained Earnings

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (10%)4,000

Total Assets$12,000Preferred Stock (11.9%)1,000

Common Stock(15%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

40%

10%

50%

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)


Cost of capital

Computing WACC - using Retained Earnings

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (10%)4,000

Total Assets$12,000Preferred Stock (11.9%)1,000

Common Stock(15%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

40%

10%

50%

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%


Cost of capital

Computing WACC - using Retained Earnings

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (10%)4,000

Total Assets$12,000Preferred Stock (11.9%)1,000

Common Stock(15%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

40%

10%

50%

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%

+ .50 x 15%


Cost of capital

Computing WACC - using Retained Earnings

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (10%)4,000

Total Assets$12,000Preferred Stock (11.9%)1,000

Common Stock(15%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

40%

10%

50%

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%

+ .50 x 15% = 11.09%


Cost of capital

Computing WACC

  • If use newly issued common stock, use knc rather than kcs for the cost of the equity portion.

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

knc


Cost of capital

Computing WACC - using New Common Shares

Balance Sheet

Assets Liabilities

Current Assets$5,000Current Liabilities$2,000

Plant & Equipment 7,000Bonds (10%)4,000

Total Assets$12,000Preferred Stock (11.9%)1,000

Common Stock(16.25%)5,000

Tax Rate = 40% Total Liabilities and

Owners Equity$12,000

WACC= k0 =%Bonds x Cost of Bonds x (1-T)

+ %Preferred x Cost of Preferred

+ %Common x Cost of Common Stock

WACC = .40 x 10% (1-.4)

+ .10 x 11.9%

+ .50 x 16.25% = 11.72%


Weighted marginal cost of capital

Weighted Marginal Cost of Capital

  • A firm’s cost of capital will change as it is raises more and more capital

    • Retained earnings will be used up at some level

    • The cost of other sources may rise beyond a certain amount of money has been raised


Weighted marginal cost of capital1

Weighted Marginal Cost of Capital

  • A firm’s cost of capital will changes as it is raising more and more capital

    • Retained earnings will be used up at some level

    • The cost of other sources may rise beyond a certain amount of money raised

    • Therefore, beyond a point, the WACC will rise.

  • Calculate the point at which the cost of capital increases


Weighted marginal cost of capital2

  • Amt of lower cost capital that can

    • be raised before component cost rises

Weight of this kind of capital

in the capital structure

Weighted Marginal Cost of Capital

  • A firm’s cost of capital will changes as it is raising more and more capital

    • Retained earnings will be used up at some level

    • The cost of other sources may rise beyond a certain amount of money raised

  • Calculate the point at which the cost of capital increases

Break in cost

of capital curve

=


Weighted marginal cost of capital3

Retained earnings

available for reinvesting

Percentage of

common financing

Weighted Marginal Cost of Capital

Break in cost

of capital curve

=

If Green Apple Company has $100,000 of internally generated common:


Weighted marginal cost of capital4

Retained earnings

available for reinvesting

Percentage of

common financing

Weighted Marginal Cost of Capital

Break in cost

of capital curve

=

If Green Apple Company has $100,000 of internally generated common:

$100,000

.50

Break in cost

of capital curve

=


Weighted marginal cost of capital5

Retained earnings

available for reinvesting

Percentage of

common financing

Weighted Marginal Cost of Capital

Break in cost

of capital curve

=

If Green Apple Company has $100,000 of internally generated common:

$100,000

.50

Break in cost

of capital curve

=

= $200,000


Weighted marginal cost of capital6

Retained earnings

available for reinvesting

Percentage of

common financing

Weighted Marginal Cost of Capital

Break in cost

of capital curve

=

If Green Apple Company has $100,000 of internally generated common:

$100,000

.50

Break in cost

of capital curve

=

= $200,000

Once $200,000 is raised from all sources, the cost of capital will rise because all the lower cost retained earnings will be used up.


Weighted marginal cost of capital7

12%

11%

10%

9%

400,000

0

100,000

200,000

300,000

Weighted Marginal Cost of Capital

  • Marginal weighted cost of capital curve:

11.09%

Cost of Capital using internal common stock

Weighted Cost of Capital

Total Financing


Weighted marginal cost of capital8

12%

11%

10%

9%

400,000

0

100,000

200,000

300,000

Weighted Marginal Cost of Capital

  • Marginal weighted cost of capital curve:

11.09%

Weighted Cost of Capital

Break-Point for common equity

Total Financing


Weighted marginal cost of capital9

12%

11%

10%

9%

400,000

0

100,000

200,000

300,000

Weighted Marginal Cost of Capital

  • Marginal weighted cost of capital curve:

Cost of Capital using new common equity

11.72%

11.09%

Cost of Capital using internal common stock

Weighted Cost of Capital

Total Financing


Weighted marginal cost of capital10

12%

11%

10%

9%

400,000

0

100,000

200,000

300,000

Weighted Marginal Cost of Capital

  • Marginal weighted cost of capital curve:

11.72%

11.09%

Weighted Cost of Capital

Total Financing


Making decisions

Making Decisions

  • Choosing Projects Using Weighted Marginal Cost of Capital

    • Graph IRR’s of potential projects

Marginal weighted cost of capital curve:

12%

Project 1

IRR = 12.4%

11%

Project 2

IRR = 12.1%

Weighted Cost of Capital

10%

Project 3

IRR = 11.5%

9%

400,000

0

100,000

200,000

300,000

Total Financing


Making decisions1

Making Decisions

  • Choosing Projects Using Weighted Marginal Cost of Capital

    • Graph IRR’s of potential projects

    • Graph Weighted Marginal Cost of Capital

Marginal weighted cost of capital curve:

12%

Project 1

IRR = 12.4%

11%

Project 2

IRR = 12.1%

Weighted Cost of Capital

10%

Project 3

IRR = 11.5%

9%

400,000

0

100,000

200,000

300,000

Total Financing


Making decisions2

Making Decisions

  • Choosing Projects Using Weighted Marginal Cost of Capital

    • Graph IRR’s of potential projects

    • Graph Weighted Marginal Cost of Capital

    • Choose projects whose IRR is above the weighted marginal cost of capital

Marginal weighted cost of capital curve:

Accept Projects #1 & #2

12%

Project 1

IRR = 12.4%

11%

Project 2

IRR = 12.1%

Weighted Cost of Capital

10%

Project 3

IRR = 11.5%

9%

400,000

0

100,000

200,000

300,000

Total Financing


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