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Chap 13_Cost of Capital - Cost of Capital Click to edit...

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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Click to edit Master subtitle style Cost of Capital
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Chapters The material covers two chapters that are not adjacently discussed in the book: Chapters 13 and 18 (Sec 18.7)
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Definitions Cost of Debt Capital The promised return to debt holders Cost of Equity Capital : The minimal return expected by stockholders Weighted average cost of capital (WACC): The after-tax weighted average cost of raising additional debt, common stock and preferred stock. WACC = wd x kd (1-t) + ws x ks + wp x kp For most decisions, only marginal cost of capital (WACC of raising additional funds) is important.
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Pre-tax Cost of Debt Yield to maturity is the value of ‘i’ that solves If firm can sell the bonds at the market price then the nominal cost of debt for these firms will be the YTM. But firms incur floatation costs when they place securities. Actual proceeds equal Pdebt – Floatation costs To calculate firms before tax cost of debt Use Pdebt as actual proceeds, and solve for ‘i’.
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Factors determining Cost of Debt Market interest rates (Treasury Rate) Default Probability (Credit Rating) Debt Ratio Interest Coverage Ratio Operating Income to Sales or Assets Liquidity Smaller the firm, lower the rating, and longer the time since issuance, the lower the liquidity.
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Source: Bonds Online. Yahoo provides data for AAA,AA, and A: http://finance.yahoo.com/bonds/composite_bond_rates Reuters Corporate Spreads for Industrials Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr Aaa/AAA 13 17 20 37 59 77 93 Aa1/AA+ 35 36 39 57 77 90 108 Aa2/AA 37 39 41 64 80 93 116 Aa3/AA- 39 45 47 74 86 96 118 A1/A+ 47 74 77 90 96 116 134 A2/A 62 79 81 91 98 118 135 A3/A- 67 81 85 96 106 125 140 Baa1/BBB+ 82 100 101 117 134 155 176 Baa2/BBB 87 104 109 129 142 165 181 Baa3/BBB- 92 105 110 137 156 180 192 Ba1/BB+ 155 175 185 215 235 255 305 Ba2/BB 165 185 195 225 245 265 315 Ba3/BB- 175 195 205 235 255 275 325 B1/B+ 270 290 300 325 360 385 435 B2/B 280 300 310 335 370 395 445 B3/B- 290 310 320 355 380 405 455 Caa/CCC 345 355 365 430 480 535 575
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Cost of Equity Even if firm uses internally generated funds for its investments, it has costs. The cost is the opportunity cost of capital for its stockholders. Compute cost of equity capital in two ways: Use the SML Use discounted cash-flow models such as the constant dividend growth model. Include floatation costs in price.
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M G M T 50 5, Fa ll 20 11 RWJ, Chapters 13, 18 Using CAPM Estimate historical betas Even though we need current risk, we use historical risk as an estimate for current risk. Regress historical returns on the security of interest with the market’s return. The slope of the regression is our estimate of beta.
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