Web Appendix 10A

Web Appendix 10A - 19819_10Aw_p1-4.qxd 1/19/06 10:38 AM...

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10A-1 In the text we calculated the WACC when all of the new common equity comes from retained earnings. Equation 10A-1 is a modified version of the WACC equation that allows equity to come from either retained earnings or new common stock: WEB APPENDIX WEB APPENDIX 10A The Cost of New Common Stock and the WACC 1 The WACC is the cost of investor-supplied capital used to finance new projects. The debt component of the target capital structure includes only interest-bearing, investor-supplied debt—long-term bonds and bank notes payable. It does not include accounts payable and accruals because those items are not provided by investors. 51 1 (10A-1) w c r s or w c r e w p r p w d r d 1 1 2 T 2 WACC 5 a % debt After-tax cost of debt ¢ 1 ° % preferred stock ¢° Cost of preferred stock ¢ 1 ° % common equity Cost of common equity ¢ Recall, Allied’s target capital structure calls for 45 percent debt, 2 percent preferred stock, and 53 percent common equity. In Chapter 10, we saw that Allied’s before-tax cost of debt is 10 percent; its after-tax cost of debt is r d (1 2 T) 5 10% (0.6) 5 6.0%; its cost of preferred stock is 10.3 percent; its cost of common equity from retained earnings is 13.4 percent; and its marginal tax rate is 40 percent. We also noted that if all of its new equity comes from retained earnings, then its WACC, designated WACC 1 , would be 10.0 percent: Under these conditions, every dollar of new capital that Allied raises would consist of 45 cents of debt with an after-tax cost of 6 percent, 2 cents of preferred stock with a cost of 10.3 percent, and 53 cents of common equity (all from additions to retained earnings) with a cost of 13.4 percent. The average cost of each whole dollar, or the WACC, would be 10 percent. 1 This WACC is good to be used in a variety of analyses (for example, capital budgeting and managerial performance), so long as the equity requirement in the optimal capital budget can be fully funded by retained earnings. But, what if new equity is required? When will we know when new common stock must be issued? What WACC must be used then?
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Web Appendix 10A - 19819_10Aw_p1-4.qxd 1/19/06 10:38 AM...

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