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Chapter 10 - Web Appendix 10A

Chapter 10 - Web Appendix 10A - WEB APPENDIX 10A The Cost...

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WEB APPENDIX 10A The Cost of New Common Stock and WACC Recall that Allied s target capital structure calls for 45% debt, 2% preferred stock, and 53% common equity. In Chapter 10, we saw that Allied s before-tax cost of debt is 10%, its after-tax cost of debt is r d (1 ± T) ¼ 10%(0.6) ¼ 6.0%, its cost of preferred stock is 10.3%, its cost of common equity from retained earnings is 13.5%, and its marginal tax rate is 40%. We also noted that if all of its new equity comes from retained earnings, its WACC, designated WACC 1 , would be 10.1%: WACC 1 ¼ w d r d ð 1 ± T Þ þ w P r P þ w C r S ¼ 0 : 45 ð 10% Þð 0 : 6 Þ þ 0 : 02 ð 10 : 3% Þ þ 0 : 53 ð 13 : 5% Þ ¼ 10 : 1% Under these conditions, every dollar of new capital that Allied raises would consist of 45 cents of debt with an after-tax cost of 6%, 2 cents of preferred stock with a cost of 10.3%, and 53 cents of common equity (all from additions to retained earnings) with a cost of 13.5%. The average cost of each whole dollar, or the WACC, would be 10.1%. 1 This WACC is good for a variety of analyses (for example, capital budgeting and managerial performance) as long as the equity requirement in the optimal capital budget can be fully funded by retained earnings. But what if new equity is required? When will we know when new common stock must be issued? What WACC must be used then? In Chapter 10, we also calculated Allied s retained earnings breakpoint and the cost of issuing new common stock. Recall that the retained earnings breakpoint can be calculated as follows: Retained earnings breakpoint = Addition to retained earnings Common equity fraction Allied s addition to retained earnings in 2009 is expected to be $66 million and its target capital structure consists of 45% debt, 2% preferred, and 53% equity. Therefore, its retained earnings breakpoint is as follows: Retained earnings breakpoint ¼ $66 = 0 : 53 ¼ $124 : 5 million Recall that in Chapter 10, when we calculated Allied s cost of new common stock, we modified the DCF approach to account for flotation costs using the following equation: Cost of equity from new stock issues ¼ r e ¼ D 1 P 0 ð 1 ± F Þ þ g
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