Chapter 9 The Cost of Capital ANSWERS TO END-OF-CHAPTER QUESTIONS 9-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital—-debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. The after-tax cost of debt, r d (1 - T), is the relevant cost to the firm of new debt financing. Since interest is deductible from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus, r d (1 - T) is the appropriate component cost of debt (in the weighted average cost of capital). b. The cost of preferred stock, r ps , is the cost to the firm of issuing new preferred stock. For perpetual preferred, it is the preferred dividend, D ps , divided by the net issuing price, P n . Note that no tax adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments on preferred stock are not tax deductible. The cost of new common equity, r e , is the cost to the firm of equity obtained by selling new common stock. It is, essentially, the cost of retained earnings adjusted for flotation costs. Flotation costs are the costs that the firm incurs when it issues new securities. The amount actually available to the firm for capital investment from the sale of new securities is the sales price of the securities less flotation costs. Note that flotation costs consist of (1) direct expenses such as printing costs and brokerage commissions, (2) any price reduction due to increasing the supply of stock, and (3) any drop in price due to informational asymmetries. c. The target capital structure is the relative amount of debt, preferred stock, and common equity that the firm desires. The WACC should be based on these target weights. d. There are considerable costs when a company issues a new security, including fees to an investment banker and legal fees. These costs are called flotation costs. The cost of new common equity is higher than that of common equity raised internally by reinvesting earnings. Project’s financed with external equity must earn a higher rate of return, since they project must cover the flotation costs. 9-2 The WACC is an average cost because it is a weighted average of the firm's component costs of capital. However, each component cost is a marginal cost; that is, the cost of new capital. Thus, the WACC is the weighted average marginal cost of capital. Answers and Solutions: 9- 1
9-3 Probable Effect on r d (1 - T) r s WACC a. The corporate tax rate is lowered. + 0 + b. The Federal Reserve tightens credit. + + + c. The firm uses more debt; that is, it increases its debt/assets ratio. + + 0 d. The firm doubles the amount of capital it raises during the year.
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