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Optimal Capital Budgeting Strategies Explained: A Guide to Cost of Capital

Learn about the cost of capital, liabilities, assets, debt, preferred stock, bank, common stock, and more in this comprehensive guide. Understand the weighted average cost of capital, marginal cost of capital, and investment opportunity schedules. Discover how to navigate capital structure decisions for optimal budgeting.

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Optimal Capital Budgeting Strategies Explained: A Guide to Cost of Capital

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  1. Chapter 10 Cost of Capital • Liabilities & Equity Assets • Debt • Preferred Stock $ Bank 14% • Common Stock 5% R.O.I. • (cost of $) • Total Liabilities = Total Assets • & Equity

  2. Chapter 10 Cost of Capital • Capital Structure • $ % • Debt $50 50% • Preferred 30 30% • Common 20 20% • Total $100 100%

  3. Chapter 10 Cost of Capital • Cost of $ • $ % k (given) • Debt $50 50% 10% • Preferred 30 30% 12% • Common 20 20% 14% • Total $100 100%

  4. Chapter 10 Cost of Capital • Wt’d Avg Cost • Cost of $ of Capital • $ % k (given) tax 40% • Debt $50 50% 10% 0.5(10%)x(1-tax)=3% • Preferred 30 30% 12% 0.3(12%) =3.6% • Common 20 20% 14% 0.2(14%) =2.8% • Total $100 100% WACC =9.4%

  5. (1) Cost of Old Debt (Kd) • Kd= interest = 10 =10% • principal 100 • (2) Cost of Old Preferred Stock (Kps) • Kps= Dividend to P.S. = 12 = 12% • P.S. price 100 • (3) Cost of Old Common Stock (Ks) • Ks= D1+ g = 2 + 4% = 14% • P0 20 • Ks = Risk Free Rate + Risk Premium

  6. For the following example... • FLOTATION COST • f = Flotation Cost = 5%

  7. (1) Cost of New Debt (Kd) • Kd= interest =10 = 10.53% • principal(1-f) 100(1-.05) • (2) Cost of New Preferred Stock (Kps) • Ks=Dividend to P.S. = 12 = 12.63% • P.S. price (1-f) 100(1-.05) • (3) Cost of New Common Stock (Ks) • Ks= D1 + g = 2 + 4% = 14.53% • P0 (1-f) 20(1-.05) • Ks = Risk Free Rate + Risk Premium

  8. Chapter 10 Cost of Capital • Wt’d Ave. Cost • Cost of $ of Capital • $ % k (given) & tax @ 40% • Debt $50 50% 10.53% 0.5(.1053)x(1-tax)=3.16% • Pref. 30 30% 12.63% 0.3(.1263) =3.79% • Comm. 20 20% 14.53% 0.2(.1453) =2.91% • Total $100 100% WACC =9.86% • Marginal Cost of Capital (MCC) = 9.86%

  9. WACC=weighted cost of capital MCC=marginal cost of capital IOS=investment opportunity schedule Percent a = 16% b = 14% c = 12% WACC = 9.86% MCC WACC = 9.50% WACC = 9.40% d = 8% IOS New capital raised & invested during the year Optimal Capital Budget

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