08-Cost-of-capital - The Cost of Capital Cost of capital...

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Cost of Capital 1 The Cost of Capital Cost of capital components Debt Preferred Common equity WACC MCC IOS
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Cost of Capital 2 What sources of capital should be included in a firm’s WACC? Long-term debt Preferred stock Common equity (including): Retained earnings New common stock
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Cost of Capital 3 Stockholders focus on after-tax cash flows. Thus, focus on A-T capital costs , i.e., use A-T costs in WACC. Only R d needs adjustment. Should we focus on before-tax or after-tax capital costs?
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Cost of Capital 4 Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions which involve raising new capital. So, focus on today’s marginal costs .
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Cost of Capital 5 Cost of debt (R d )? Coupon = 12% semi Price = $1,153.72; 15 years. 60 60 + 1,000 60 0 1 2 30 i = ? 30 -1153.72 60 1000 5.0% periodic x 2 = R d = 10% N I/YR PV FV PMT -1,153.72 INPUTS OUTPUT
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Cost of Capital 6 Component cost of Debt Interest is tax deductible, so R d AT = R d BT (1 - T) = 10%(1 - 0.40) = 6% Debt flotation costs small. Ignore. May need to incorporate yield curve differences.
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Cost of Capital 7 What’s the cost of preferred stock (R ps )? P ps = $113.10; 10%Q; Par = $100; F = $2 Use this formula: R ps = = = = 0.090 = 9.0% 0.1($100) $113.10 - $2.00 D ps P net $10 $111.10
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Cost of Capital 8 Note Flotation costs for pfd. are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just R ps . Nominal R ps is used. Capital budgeting CFs are nominal. Use nominal values for component costs.
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Cost of Capital 9 Is preferred stock more or less risky to investors than debt? More risky; company not required to
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08-Cost-of-capital - The Cost of Capital Cost of capital...

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