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Unformatted text preview: 10 Chapter model 12/12/08 Chapter 10. The Cost of Capital EXAMPLE 10% Tax rate 40% 6.00%=B15*(1-B16) EXAMPLE Preferred dividend $10.00 Preferred price $97.50 10.3% THE CAPM APPROACH EXAMPLE Risk-free rate 5.6% Market risk premium 5.0% Beta 1.48 5.6% Beta 5.6% 0.00 5.6% 0.50 5.6% 1.00 5.6% 1.50 5.6% 2.00 5.6% BOND-YIELD-PLUS-RISK-PREMIUM APPROACH EXAMPLE Bond yield 10% Equity RP 4% Minimum RP 3% Maximum RP 5% 13% 14% 15% THE DISCOUNTED CASH FLOW APPROACH EXAMPLE $23.06 $1.25 13.7% g 8.3% AVERAGING THE THREE ESTIMATES CAPM 5.6% RISK PREMIUM 14.0% DISCOUNTED DIVIDENDS (DCF) 13.7% Cost of retained earning for WACC = 11.1% 13.50% EXAMPLE $23.06 14.3% $1.25 13.7% g 8.3% Additional cost 0.6% % Flotation cost 10% % Flotation cost 0.6% 13.50% + 0.6% = 14.1% Retained Earnings Breakpoint Retained earnings breakpoint = Addition to retained earnings for the year Equity fraction EXAMPLE RE addition $66 45% 2% 53% Retained earnings breakpoint = $66 0.53 Retained earnings breakpoint = $124.5 EXAMPLES 45% 6.0% 2% 10.3% WACC = 10.1% 53% 13.5% 45% 6.0% 2% 10.3% WACC = 10.4% 53% 14.1% The cost of capital is a vital element in the capital budgeting process. For a project to be accepted, it must provide a return that exceeds its cost of capital, or hurdle rate. The cost of capital also serves three other purposes: (1) It is used to help determine the EVA, (2) managers use the cost of capital when deciding between buying and leasing, and (3) the cost of capital is used in the regulation of electric, gas, and telephone companies. The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses to finance its assets, or its WACC. There is an overal , or corporate, WACC which reflects the average riskiness of al the firm's assets. COST OF DEBT, r d (1 − T) (Section 10-3) The relevant cost of debt is the after-tax cost of new debt, taking into account the tax deductibility of interest. The after-tax cost of new debt is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate. Find the after-tax cost of debt for a company that pays 10% interest on debt and is subject to a 40% marginal tax rate. B-T r d A-T r d = COST OF PREFERRED STOCK, r p (Section 10-4) The cost of preferred stock is simply the preferred dividend divided by the price the company wil receive if it issues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible. What is the cost of preferred stock for a company that pays a preferred dividend of $10 per share if the company could sel new preferred for $97.50 per share? r p = COST OF RETAINED EARNINGS, r s (Section 10-5) The cost of retained earnings is simply an opportunity cost equal to the return investors expect to earn on the firm's stock, or r s ....
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