Chapter 10 - FIN 3403 - PowerPoint

Chapter 10 - FIN 3403 - PowerPoint - FIN 3403 CHAPTER 10...

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FIN 3403 Module 6 - Chapter 10 Page 1 CHAPTER 10 The Cost of Capital Cost of Capital FIN 3403 - Business Finance Other Topics Component Costs WACC / MCC Debt Preferred Equity Basics Calculations Divisional Screening Rates Types of Risk Breakpoints Component Costs of Capital ± When calculating component costs of capital, should we be concerned with before-tax or afte -tax costs? after tax costs? ² Stockholders are concerned about after-tax cash flows. Therefore, our component costs should be on an after-tax basis.
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FIN 3403 Module 6 - Chapter 10 Page 2 Component Costs of Capital ± Should we focus on historical (embedded) costs of capital or new (marginal) costs of capital? ² Our investment decisions will involve the raising of new capital. Therefore, concern should be on marginal costs (WACC). Component Costs of Capital ± What is the relationship between the return required by investors and the return the firm must earn? ² In general, because of flotation costs, the firm must earn a return higher than what is required by the investors. Cost of Debt ² 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%. ± What are the before-tax and after- tax costs of debt?
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FIN 3403 Module 6 - Chapter 10 Page 3 940.25 [50][PVIFA r D ,20 2 ] + [1,000][PVIF r D ,20 ] Cost of Debt r D 11% r D (1-T) (.11)(1-.46) 5.94% 2 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 Interes $0 00 $5 50 $5 50 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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FIN 3403 Module 6 - Chapter 10 Page 4 Debt and Leverage Interest = $5.50 Δ Taxes = - $2.53 Δ 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 D = (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% 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
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FIN 3403 Module 6 - Chapter 10 Page 5 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. ² What are the costs (investor and firm) of preferred stock? Cost of Preferred
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This note was uploaded on 01/11/2012 for the course FIN 3403 taught by Professor Tapley during the Fall '06 term at University of Florida.

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Chapter 10 - FIN 3403 - PowerPoint - FIN 3403 CHAPTER 10...

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