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Chapter10

# Chapter10 - Chapter 10 Determining the Cost of Capital...

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Mini Case: 10 - 1 Chapter 10 Determining the Cost of Capital ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS The answers to a number of the question are illustrated in the Excel model. 10-1 (1) Debt , (2) preferred stock , and common equity from (3) sale of common stock and (4) retained earnings. Keep the fact that common equity can be divided into retained earnings and new common stock in mind, and also note that there are many different types of debt, with differing costs, as we discuss in later chapters. From an investor’s standpoint, debt is the least risky holding and thus provides the lowest return. Therefore, it has the lowest cost, followed by preferred, and then common stock. Because of flotation costs, equity from retained earnings has a lower cost than equity from issuing new common stock. Also, note that interest is deductible to the issuing company, so the already-low cost of debt is reduced further by multiplying the interest rate by (1-T). The end result is that the after-tax cost of debt is lowest, preferred is next, and common equity is highest. Note also, however that corporations can exclude 70% of preferred dividends received from their taxable income, so corporate investors can accept a lower pre-tax yield on preferred stock dividends than the yield on bonds and still obtain a higher after-tax return on the preferred. Thus, the pre-tax cost of preferred is often lowest, followed by debt, and then common stock. Still, for cost of capital estimating purposes, it is the after-tax cost that is relevant . 10-2 The WACC is simply a weighted average of the firm’s component costs of capital.

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Mini Case: 10 - 2 10-3 The weights used should be bases on the firm’s target capital structure . To illustrate, suppose a company has 50-50 debt and equity at book value, but its stock sells for 1.5 times book and it uses the market value ratio as the target. Here is the situation: Book Value Data Market Value Data Debt \$50 50% Debt \$50 40% Equity 50 50 Equity \$75 60 \$100 100% \$125 100% Using book value weights (50-50) would put too much weight on debt, and since debt has the lower cost, this would bias the WACC downward. The market value weights would be 40% debt and 60% equity, and this would increase the WACC. If the firm plans to finance using the target weights, then the WACC based on the 40:60 ratio is correct. Note also that even if the firm plans to use only debt during a given year, in the capital budgeting process we should still use the target weight based WACC, for otherwise the hurdle rate would be too low one year and too high the next. An interesting issue arises if the firm’s actual capital structure is far removed from the target, say an actual capital structure with 100% equity and a target of 50-50 debt/equity. Then, the firm might be able to finance with only debt for a number of years while the
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Chapter10 - Chapter 10 Determining the Cost of Capital...

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