FM12e_Ch 10_COC

# FM12e_Ch 10_COC - CHAPTER10 TheCostofCapital 1...

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1 CHAPTER 10 The Cost of Capital

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2 Topics in Chapter Cost of Capital Components Debt Preferred Common Equity WACC
3 What types of long-term  capital do firms use? Long-term debt Preferred stock Common equity

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4 Capital Components Capital components are sources of funding  that come from investors. Accounts payable, accruals, and deferred  taxes are not sources of funding that come  from investors, so they are not included in the  calculation of the cost of capital. We do adjust for these items when calculating  the cash flows of a project, but not when  calculating the cost of capital.
5 Before-tax vs. After-tax  Capital Costs Tax effects associated with financing  can be incorporated either in capital  budgeting cash flows or in cost of  capital. Most firms incorporate tax effects in the  cost of capital.  Therefore, focus on  after-tax costs. Only cost of debt is affected.

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6 Historical (Embedded) Costs  vs. New (Marginal) Costs The cost of capital is used primarily to  make decisions which involve raising  and investing new capital.  So, we  should focus on marginal costs.
7 Cost of Debt Method 1: Ask an investment banker  what the coupon rate would be on new  debt. Method 2: Find the bond rating for the  company and use the yield on other  bonds with a similar rating. Method 3: Find the yield on the  company’s debt, if it has any.

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8 A 15-year, 12% semiannual bond  sells for \$1,153.72.  What’s r d ?    60 60 + 1,000 60 0 1 2 30 i = ? -1,153.72 ... 30 -1153.72 60 1000 5.0% x 2 = r d = 10% N I/YR PV FV PMT INPUTS OUTPUT
9 Component Cost of Debt Interest is tax deductible, so the after  tax (AT) cost of debt is:    r AT= r d  BT(1 - T)  r AT = 10%(1 - 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore.

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10 Cost of preferred stock: P P  =  \$113.10; 10%Q; Par = \$100; F = \$2. Use this formula: r ps = D ps P ps (1-F) = 0.1(\$100) \$113.10(1-0.05) = \$10 \$111.10 = 0.090=9.0%
11 Time Line of Preferred 2.50 2.50 2.50 0 1 2 r ps =? -111.1 ... \$111.10= D Q r Per = \$2.50 r Per r Per = \$2.50 \$111.10 = 2.25%; r ps(Nom) = 2.25%(4) = 9%

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12 Note: Flotation costs for preferred 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.
13 Is preferred stock more or less  risky to investors than debt? More risky; company not required to pay

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## This note was uploaded on 12/12/2011 for the course ECONOMICS 101 taught by Professor Thoman during the Spring '09 term at Abu Dhabi University.

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FM12e_Ch 10_COC - CHAPTER10 TheCostofCapital 1...

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