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Chapter10CostofCapital

# Chapter10CostofCapital - OEM 2009 Program Component Costs...

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OEM 2009 Program The Cost of Capital Page 1 CHAPTER 10 The Cost of Capital Component Costs of Capital When calculating component costs of capital, should we be concerned with before-tax or after-tax costs? after tax costs? Stockholders are concerned about after-tax cash flows. Therefore, our component costs should be on an after-tax basis. Component Costs of Capital Should we focus on historical (embedded) costs of capital or new (marginal) costs of capital? Our investment decisions will involve the raising of new capital. Therefore, concern should be on marginal costs (WACC). Component Costs of Capital What is the relationship between the return required by investors and the return the firm must earn? In general, because of flotation costs, the firm must earn a return higher than what is required by the investors. Cost of Debt A firm can issue debt with10-years to maturity and paying \$50 in interest every 6 months. Flotation t li ibl d th fi costs are negligible and the firm believes that it can net \$940.25 per bond. The tax rate is 46%. What are the before-tax and after- tax costs of debt? 940.25 [50][PVIFA r D ,20 2 ] + [1,000][PVIF r D ,20 ] Cost of Debt r D 11% r D (1-T) (.11)(1-.46) 5.94% 2

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OEM 2009 Program The Cost of Capital Page 2 Debt and Leverage Assumptions : Firm A: Stock equals 200 D bt l 0 Debt equals Firm B: Stock equals 150 Debt equals 50 r D 11% Debt and Leverage Income Firm A Firm B Change Revenue \$120.00 \$120.00 \$0.00 Expense -\$70.00 -\$70.00 \$0.00 Interest \$0 00 \$5 50 \$5 50 \$0.00 -\$5.50 \$5.50 EBT \$50.00 \$44.50 -\$5.50 Taxes (46%) -\$23.00 -\$20.47 \$2.53 Net Income \$27.00 \$24.03 -\$2.97 Debt and Leverage Interest = \$5.50 Δ Taxes = - \$2.53 Δ Net Income = - \$2.97 AT r D = (\$5.50 - \$2.53) / (\$50.00) AT r D = (\$2.97) / (\$50.00) AT r D = 5.94% AT r D = (11.0%)(1-.46) = 5.94% Debt and Leverage Firm A : r S = \$27.00 / \$200.00 = 13.50% Firm B : r D = \$ 5.50 / \$ 50.00 = 11.00% r S = \$24.03 / \$150.00 = 16.02% Debt and Leverage r S = ROA (unlevered) + Leverage effect + Tax shield on debt 16.02% = .1350 + (.1350-.1100)(50/150) + (.1100-.0594)(50/150) 16.02% = .1350 + .0083 + .0169 Cost of Preferred A firm can issue preferred stock that will pay a \$10 dividend. Investors are willing to pay \$130 f h h b t b f for each share but, because of flotation costs, the firm will only net \$125 per share. What are the costs (investor and firm) of preferred stock?