Ch 9 Slide Show

Ch 9 Slide Show - CHAPTER9 TheCostofCapital 1...

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1 CHAPTER 9 The Cost of Capital
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2 Topics in Chapter Cost of capital components Debt Preferred stock Common equity WACC Factors that affect WACC Adjusting cost of capital for risk
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Value =                         +                         +  ··· + FCF 1 FCF 2 FCF (1 + WACC) 1 (1 + WACC) (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC ) Net operating profit after taxes Required investments in operating capital = Determinants of Intrinsic Value: The Weighted Average Cost of Capital
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4 What types of long-term  capital do firms use? Long-term debt Preferred stock Common equity
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5 Capital Components Capital components are sources of funding  that come from investors. Accounts payable, accruals, and deferred  taxes are not sources of funding that come  from investors, so they are not included in the  calculation of the cost of capital. We do adjust for these items when calculating  the cash flows of a project, but not when  calculating the cost of capital.
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6 Before-tax vs. After-tax  Capital Costs Tax effects associated with financing  can be incorporated either in capital  budgeting cash flows or in cost of  capital. Most firms incorporate tax effects in the  cost of capital.  Therefore, focus on  after-tax costs. Only cost of debt is affected.
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7 Historical (Embedded) Costs  vs. New (Marginal) Costs The cost of capital is used primarily to  make decisions which involve raising  and investing new capital.  So, we  should focus on marginal costs.
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8 Cost of Debt Method 1: Ask an investment banker  what the coupon rate would be on new  debt. Method 2: Find the bond rating for the  company and use the yield on other  bonds with a similar rating. Method 3: Find the yield on the  company’s debt, if it has any.
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9 A 15-year, 12% semiannual bond  sells for $1,153.72.  What’s r d ?    60 60 + 1,000 60 0 1 2 30 r d  = ? -1,153.72 ... 30        -1153.72   60    1000      5.0% x 2 = r d  = 10%     N I/YR PV FV PMT INPUTS OUTPUT
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10 Component Cost of Debt Interest is tax deductible, so the after  tax (AT) cost of debt is:    r AT = r d  BT(1 – T) r AT = 10%(1 – 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore.
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11 Cost of preferred stock: P ps  = $116.95;  10%Q; Par = $100; F = 5% Use this formula: r ps = D ps P ps (1 – F) = 0.1($100) $116.95(1 – 0.05) = $10 $111.10 = 0.090 = 9.0%
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Time Line of Preferred 2.50 2.50 2.50 0 1 2 r ps  = ? -111.1
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This note was uploaded on 02/02/2011 for the course FINC 350 taught by Professor Johnson during the Spring '11 term at UCLA.

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Ch 9 Slide Show - CHAPTER9 TheCostofCapital 1...

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