Definitions: Capital Components:common stock, preferred stock, debt
Component cost: required rate of return on each of the capital components
Weighted average cost of capital (WACC): weighted average of all the cost components
Target capital structure: say a firm is 60% common equity, 10% preferred and 30% debt, thats its capital structure
Cost of Debt (rate of return debtholders require * (1-tax))
This is also called cost of
New
debt
Cost of preferred stock (preferred dividends / net issuing price)
Net issuing price is the price firms receive after deducting floating costs
Ex. of costs of preferred stock: Say X has pref. Stock, Dividend = 10$ / share, selling price = 100$ / share, floatation = 2.5%
or 2.5$ / share, therefore it would be 10/(100-2.5) = 10.3 %
Costs of common equity
This occurs because the investors could otherwise reinvest their money somewhere else, so to stay with the company
they need a rate of return to match the investments they could get elsewhere
3 methods to calculate: 1) CAPM MODEL:
Finding Rm using DCF model, rm = ((d0*(1+g))/p0) + g = RF + Rpm = Rm, with RM
calculate the return on equity by using CAPM model
2) DCF APPROACH:
Rs= ((Do*(1+g))/Po) + G
3) BOND YIELD + BOND
RISK PREMIUM APPROACH:
just bond yield + bond risk premium
WEIGHTED AVERAGE COST OF CAPITAL:
% of structure thats debt * RoR debtholders want * (1-t) + % of structure thats preferred stock + preferred dividends / (pref stock price – floating
costs) + % of structure thats equity * Rs
| | | NOTE:
Rs is cost of common equity, use one of the three methods
Cost Of New (External) Equity:
Re = ((Do*(1+g))/(Po*(1-F))) + G, F = Flotation cost %age, this all calculates the required return for new eq.
Quiz Problems: Quiz #6:
Problem #1:
RR = 13%, RFR = 7%, MRP = 4%, suppose MRP increases 2%, whats new RR? first find Beta, .13 =.07 +
x *.4; .06 = .04x; x = 1.5, now plug
in new mrp of .06 and solve x = .07 + (.06)*1.5 = 16%.
Problem 2.
d1 = 3, g = 7%, B = 1.667 and is in
equilibrium, RR on stock = 14%, RM = 10%, ppl think rm will increase 25% and RFR is unchagned, whats the new price of stock? First find
RFR; .14= RF + (.1-RF)*1.667, .14 - .1667 = RF – 1.667 RF; -.0267 = -.667RF; RF = 4%; now use CAPM, RM = .04 + ((.1*1.25) - .04) * 1.667
= 18.2%; Now use gordon model, Vt = 3 / (.182 - .07) = 26.87$
Problem 3
A has beta 1.5, B has beta .5, this means that as part of a diversified
portfolio, the expected return on stock A is greater than expected return on B
Problem 4
X has 20m$ portfolio, beta is 1.5, RFR = 4.5%, MRP =
5.5%, x will receive 5 Mill in additional funds which he will invest, wants RoR = 13$, what must the avg beta of new stocks be? First calculate
weights, 20m / (20m+5m) = 80%, so weight of the new funds is 20%, next calculate the beta of the entire portfolio, which is (.13 - .045) / .055 =
1.546, now then, total beta = weight of old beta * old beta + weight of new beta * new beta, so 1.546 = .8 * 1.5 + .2*x, solve for x, x = 1.73
Project classifications: Replacement (maintenance) –