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.
sale of common stock
Keep the fact that common equity can be divided into
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
Therefore, it has the lowest cost, followed by preferred, and then common
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
The WACC is simply a weighted average of the firm’s component costs of capital.
The weights used should be bases on the firm’s target capital structure
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
Answers and Solutions:
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