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COST OF CAPITAL CHAPTER 10. Weighted Average Cost of Capital Cost of Capital Components. Types of Capital. SOURCES OF LONG-TERM CAPITAL . From Most to Least Used Sources Retained Earnings Sale of Corporate Bonds Sale of Common Stock Sale of Preferred Stock

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cost of capital chapter 10

COST OF CAPITALCHAPTER 10

Weighted Average Cost of Capital

Cost of Capital Components

sources of long term capital
SOURCES OF LONG-TERM CAPITAL
  • 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
sources of long term capital1
SOURCES OF LONG-TERM CAPITAL
  • 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)
hurdle rate wacc or k a
HURDLE RATE [WACC or ka]
  • 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.
cost of new capital
COST OF NEW CAPITAL
  • 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
cost of new capital1
COST OF NEW CAPITAL

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.
cost of new capital2
COST OF NEW CAPITAL

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 wacc or k a1
HURDLE RATE [WACC or ka]
  • 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.
homework chapter 10
HOMEWORK CHAPTER 10
  • 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
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