Ch 10 - CHAPTER10 TheCostofCapital 0. 1. 2....

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CHAPTER 10 The Cost of Capital 0. Sources of capital 1. Component costs 2. WACC What sources of long-term capital do firms use? Calculating the weighted average cost of capital WACC = w r d (1-T) + w r p  + w c r s   0. The w’s refer to the firm’s capital structure weights. 1. The r’s refer to the cost of each component. Should our analysis focus on before-tax or after-tax capital costs? 2. Stockholders focus on After Tax (AT) Cash Flows.  Therefore, we  should focus on A-T capital costs, i.e. use A-T costs of capital in  WACC.  Only k d  needs adjustment, because interest is tax  deductible. 3. Should our analysis focus on historical (embedded) costs or new  (marginal) costs? 4. The cost of capital is used primarily to make decisions that involve  raising new capital.  So, focus on today’s marginal costs (for  WACC). Component cost of debt  WACC = w d  r d (1-T) + w p r p  + w c r s   5. r d  is the marginal cost of debt capital. 1
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6. The yield to maturity on outstanding L-T debt is often used as a  measure of r d . 7. Why tax-adjust, i.e. why r d (1-T)? A 15-year, 12% semiannual coupon bond sells for $1,153.72.  What is the cost of  debt (r d )? 8. Remember, the bond pays a semiannual coupon, so r d  = 5.0% x 2 =  10%. Component cost of debt 9. Interest is tax deductible, so  A-T r d  = B-T r d  (1-T)           = 10% (1 - 0.40) = 6% 10.Use nominal rate. 11.Flotation costs are small, so ignore them. Component cost of preferred stock  WACC = w r d (1-T) + w r p  + w r s   12. r p  is the marginal cost of preferred stock. 13.The rate of return investors require on the firm’s preferred stock. What is the cost of preferred stock? 14.The cost of preferred stock can be solved by using this formula: r p  = D p  / P p     = $10 / $111.10     = 9% Component cost of preferred stock 2
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15. Preferred dividends are not tax-deductible, so no tax adjustments  necessary.  Just use r
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This note was uploaded on 09/09/2011 for the course BUSINESS 300 taught by Professor N/a during the Spring '09 term at DeVry Chicago.

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Ch 10 - CHAPTER10 TheCostofCapital 0. 1. 2....

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