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Lecture16_winter09

Lecture16_winter09 - CAPITAL STRUCTURE AND COST OF CAPITAL...

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CAPITAL STRUCTURE AND COST OF CAPITAL
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CORRECTION OF TYPO Last lecture the formula for the LEVERED BETA with Taxes was wrong. The correct is S B t asset S 1 1
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EXAMPLE Consider Gecko Company. The Company specializes in making umbrellas. The Capital Structure of Gecko is composed by 25% in Debt and 75% in Equity. The required return of Bondholders is 5% The Beta f Gecko stock is 1.25. Also, you know that the risk-free rate is 5% and the Return of the Market Portfolio is 20% Gecko pays Corporate Taxes at a rate of 40%
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EXAMPLE What is the Cost of Capital for Gecko? We need to calculate what is the required return by the Stockholders of Gecko. % 75 . 23 % 5 % 20 * 25 . 1 % 5 * S f M S f S R R R E R R
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EXAMPLE Now we can calculate the WACC of Gecko % 56 . 18 ) 4 . 0 1 %( 5 4 1 % 75 . 23 4 3 1 wacc B S wacc R t R B S B R B S S R
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EXAMPLE Now suppose Gecko decides to produce sunglasses. Gordon Company makes sunglasses. The Beta of Gordon is 1.5. Gordon has a mix of 20% Debt and 80% Equity. Gecko wants to finance its sunglasses business the same way it finances the umbrella business.
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EXAMPLE What is the Cost of Capital for Gecko’s sunglasses business? There are a few things to consider: The risk of businesses is different. We should not use the Beta of Gecko stock for this calculation Gordon has a capital structure different than Gecko. We should not use the Beta of Gordon stock.
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EXAMPLE First we need to UNLEVER the BETA of Gordon stock. The aim is to discover what is the risk of making sunglasses. 3 . 1 8 . 0 2 . 0 4 . 0 1 1 5 . 1 4 . 0 1 1 sunglasses sunglasses gordon gordon sunglasses gordon S B
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EXAMPLE Then, we need to discover what is the risk of the stock of Gecko when making sunglasses 56 . 1 75 . 0 25 . 0 4 . 0 1 1 3 . 1 4 . 0 1 1 gecko gecko gecko sunglasses gecko S B
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EXAMPLE Now we can discover the cost of equity for Gecko, when making sunglasses We can now discover the WACC for Gecko when making sunglasses % 4 . 28 % 5 % 20 56 . 1 % 5 S R % 05 . 22 % 4 . 28 * 75 . 0 ) 4 . 0 1 %( 5 * 25 . 0
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