6thCh10P - CHAPTER10 TheCostofCapital Sourcesofcapital...

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1 CHAPTER 10 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk
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2 What sources of long-term  capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock
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3 Calculating the weighted  average cost of capital WACC = w d r d (1-T) + w p r p  + w c r s   The w’s refer to the firm’s capital  structure weights. The r’s refer to the cost of each  component.
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4 Should our analysis focus on  before-tax or after-tax capital costs? Stockholders focus on A-T CFs.   Therefore, we should focus on A-T  capital costs, i.e. use A-T costs of  capital in WACC.  Only r d  needs  adjustment, because interest is tax  deductible. If financing with 100% equity, tax is irrelevant because  the dividends are paid with after tax dollars, that are  not deductible for income tax purpose .
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5 Should our analysis focus on  historical (embedded) costs or new  (marginal) costs? The cost of capital is used primarily to  make decisions that involve raising new  capital.  So, focus on today’s marginal  costs (for WACC). How are weights determined? Use accounting numbers or market value? Use actual numbers or target capital structure?
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6 A 15-year, 12% semiannual coupon  bond sells for $1,153.72.  What is  the cost of debt (r d )? Remember, the bond pays a semiannual  coupon, so r d  = 5.0% x 2 = 10%. INPUTS OUTPUT N I/YR PMT PV FV 30 5 60 1000 -1153.72
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7 Component cost of debt Interest is  tax deductible , so  A-T r d  = B-T r d  (1-T)           = 10% (1 - 0.40) = 6% Use  nominal rate . Flotation costs are small, so  ignore   them.
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8 What is the cost of preferred  stock? The cost of preferred stock can be  solved by using this formula: r p  = D p  / P p     = $10 / $111.10     = 9%
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9 Why is the yield on preferred  stock lower than debt? Preferred stock will often have a lower B-T 
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This note was uploaded on 03/02/2011 for the course BMGT 340 taught by Professor White during the Spring '08 term at Maryland.

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6thCh10P - CHAPTER10 TheCostofCapital Sourcesofcapital...

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