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COST OF CAPITAL CHAPTER 10

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COST OF CAPITALCHAPTER 10

Weighted Average Cost of Capital

Cost of Capital Components

- From Most to Least Used Sources
- Retained Earnings
- Sale of Corporate Bonds
- Sale of Common Stock
- Sale of Preferred Stock

- Cost of capital determined by firm's capital structure (RHS of B/S).
Capital consists of:

- Debt (bonds)
- Equity (preferred and common stocks)
- Retained Earnings

- Market-based weighted-average of these costs (WACC) is also termed the hurdle rate.
WACC = Wd Kd (1-t) + Wp Kp + We Ke

- How are the weights Wi determined?
- Use accounting numbers (easiest – uses book values)
- Use market value of issued securities (preferred method)
- Firm’s cost of capital is set by market forces via investor pricing activity [implied risk assessment]
- High risk: lower prices (low P/E ratios)
- Low risk: higher prices (high P/E ratios)

- Some Observations:
- Approximately 80% of all investment projects are financed internally (from retained earnings and tax-shielded cash flows such as depreciation).
- Approximately 15% are financed by selling debt.
- Approximately 5% are financed by selling stock.

- The Cost of New Debt: Kd
- Kd = [YTM / (1 - F)] (1 - T)
- Where:
- YTM = current market yields to maturity for seasoned bonds.
- F = flotation costs as a decimal (percentage).
- T = the marginal tax rate of the firm

B.The cost of Preferred Stock; Kpfd

- Kpfd = Dpfd / [Ppfd * (1 - F)]
- Where:
- Dp = the dividend (to be) paid on the preferred stock.
- Pp = the (current) market price of preferred.
- F = Flotation costs as a percentage.

C. Cost of Equity (common & ret’d earns); Ke

Ke = D1 / (Po - F) + g

- Where:
- D1 = the expected dividend at the end of year 1.
- Po = the current price of common.
- F = Flotation cost in dollars per share.
- g = the anticipated rate of growth in dividends.

- Hurdle rate; minimum rate of return a project must earn. Ceteris paribus….
- If just the hurdle rate is earned, then value of firm is maintained.
- If less that the hurdle rate is earned, then value of firm declines.
- If more that the hurdle rate is earned, then value of firm increases.

- Questions You Should Be Able To Answer
- Why is the hurdle rate an important concept in capital budgeting?
- What important considerations must we make when computing the cost of capital?
- What factors should managers consider when planning a capital structure strategy?

- Homework Assignment
- Self-test: ST-1, parts b, e, f
- Questions: 10-1, parts a, b, h, i
- Problems: 10-1, 10-3, 10-11