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

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