FIN+4414+-+Cost+of+Capital+-+Chapter+10-1

# FIN+4414+-+Cost+of+Capital+-+Chapter+10-1 - Cost of Capital...

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Cost of Capital

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Cost of Debt A firm can issue debt with10- years to maturity and paying \$50 in interest every 6 months. Flotation costs are negligible and the firm believes that it can net \$940.25 per bond. The tax rate is 46%.
940.25 [50][PVIFA r D ,20 2 ] + [1,000][PVIF r D 11% r D (1-T) (.11)(1-.46) 5.94% r D ,20 2 ] Cost of Debt

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Debt and Leverage Assumptions : Firm A: Stock equals 200 Debt equals 0 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 EBT \$50.00 \$44.50 -\$5.50 Taxes (46%) -\$23.00 -\$20.47 -\$2.53 Net Income \$27.00 \$24.03 -\$2.97

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Debt and Leverage Interest = \$5.50 Taxes = - \$2.53 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 = (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%

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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 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?

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Cost of Preferred r P = D P / P 0 or D P / P N Investor : r P = \$10 / \$130 = 7.69% Firm : r P = \$10 / \$125 = 8.00%
Preferred and Leverage Assumptions : Firm A: Stock equals 200 Preferred equals 0 Firm B: Stock equals 150 Preferred equals 50 r P 8%

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Preferred and Leverage Income Firm A Firm B Revenue \$120.00 \$120.00 Expense -\$70.00 -\$70.00 EBT \$50.00 \$50.00 Taxes (46%) -\$23.00 -\$23.00 Net Income \$27.00 \$27.00 Preferred Dividend \$0.00 -\$4.00 Available to Common \$27.00 \$23.00
Preferred and Leverage Firm A : r S = \$27.00 / \$200.00 = 13.50% Firm B : r P = \$ 4.00 / \$ 50.00 = 8.00% r S = \$23.00 / \$150.00 = 15.33%

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Preferred and Leverage r S = ROA (unlevered) + Leverage effect 15.33% = .1350 + (.1350-.0800)(50/150) 15.33% = .1350 + .0183
Cost of Equity Distinction must be made between Retained earnings External (new issues) of equity

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Cost of Equity Methods to determine equity costs CAPM Discounted cash flow
Cost of RE: CAPM r S = r RF + [r M - r RF ][ß E ] This is the standard CAPM equation with which you are already familiar, but let’s look more closely at what this beta risk is comprised of.

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FIN+4414+-+Cost+of+Capital+-+Chapter+10-1 - Cost of Capital...

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