Cost of Capital ppt

Cost of Capital ppt - 6-1Chapter 5The Cost of...

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Unformatted text preview: 6-1Chapter 5The Cost of CapitalnCapital componentslDebtlPreferredlCommon EquitynEquity cost approacheslCAPM6-21. Long Term Debt2. Preferred Stock3. Common Equity:Retained earningsWhat capital should beincluded in the WACC?6-3Focus on before-tax orafter-tax capital costs?nThe WACC used to discount cashflows is after-tax.nTherefore, use A-T WACC.nOnly kd needs adjustment.6-4Why adjust kd?nThe cost of debt is deductible.nCosts of preferred and common are not deductible.6-5nWhat is marginal cost?nDecisions are being made regarding newcapital investment.nTherefore, the cost of the next dollar of capital is the relevant question (i.e. marginal cost).Historical vs. Marginal Cost?6-6Calculate kd:Coupon = 10% semiaannualPrice = $1,081.44; 15 yearsNPVFVI/YRPMTInputs30 -1,081.44 50 1,000Output 4.5% x 2 = kd = 9%0 1230-1,081.44505050+1,0006-7Component Cost of Debtkd AT = kd BT (1-T)= 9% (1-0.40)= 5.4%Use nominal rate.6-8nTotal costs of issuing and selling a security reduce the net proceeds from the salenThese costs are typically small on public debt issues.nMost debt is privately placeddirectly with large investors. So flotation costs are almost nonexistent.Should flotation costsbe considered?6-9nSemiannual lEAR = (1.045) 2 - 1 = 9.2%nNominal rates are generally used. nCapital budgeting CFs assumed to occur at year end; undervalues CFs.nNominal rate understates the cost of debt and overvalues CFs. nTherefore, the biases are offsetting.Should the nominal or effectiveannual cost of debt be used?6-10Would a kd estimate basedon 15-year bonds be validif the firm actually planned to issue 30-year bonds?Only if the yield curve were flat.Differences are typically small overlonger-term maturities; henceyield curve adjustments are seldom made.6-11Formula:=0.09($100)$115.00 - $2.50= 0.080 = 8.0%=$9$112.5What is the component costof preferred stock?PPS=$115; 9%Q; Par=$100; F=$2.50kPS=DPSPNet6-12Preferred Stock Cashflows128-112.502.252.25$112.50 = D$2.25k - gkPer=kPer = $2.25/$112.50 = 2.00%kNom = 2% x 4 = 8%6-13Notes on preferred:nFlotation costs for preferred aresignificant, so they are included. Usenet price.nPreferred dividends are not deductible, so no tax adjustment.Just kPS.nNominal kPS is used.6-14Is preferred stock more or lessrisky to investors than debt?nMore risky; company is not requiredto pay preferred dividends.nHowever, firms tryto pay preferreddividends. Otherwise,lcannot pay common dividends,ldifficult to raise additional funds,lpreferred stockholders may gain control of the firm.6-15Why is kPS lower than kd?...
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This note was uploaded on 12/07/2009 for the course FIRE 312 taught by Professor Salandro during the Spring '09 term at VCU.

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Cost of Capital ppt - 6-1Chapter 5The Cost of...

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