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IFM10 Ch10 Lecture

# IFM10 Ch10 Lecture - CHAPTER 10 Determining the Cost of...

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CHAPTER 10 Determining the Cost of Capital 1

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Topics in Chapter Cost of Capital Components Debt Preferred Common Equity WACC 2
What types of long-term capital do firms use? Long-term debt Preferred stock Common equity 3

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Capital Components Capital components are sources of funding that come from investors. Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital. We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital. 4
Before-tax vs. After-tax Capital Costs Tax effects associated with financing can be incorporated either in capital budgeting cash flows or in cost of capital. Most firms incorporate tax effects in the cost of capital. Therefore, focus on after- tax costs. Only cost of debt is affected. 5

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Historical (Embedded) Costs vs. New (Marginal) Costs The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs. 6
Cost of Debt Method 1: Ask an investment banker what the coupon rate would be on new debt. Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. Method 3: Find the yield on the company’s debt, if it has any. 7

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A 15-year, 12% semiannual bond sells for \$1,153.72. What’s r d ? 8 60 60 + 1,000 60 0 1 2 30 I = ? -1,153.72 ... 30        -1153.72   60    1000      5.0% x 2 = r d  = 10%     N I/YR PV FV PMT INPUTS OUTPUT
Component Cost of Debt Interest is tax deductible, so the after tax (AT) cost of debt is: r d AT = r d BT(1 - T) r d AT = 10%(1 - 0.40) = 6%. Use nominal rate. Flotation costs small, so ignore. 9

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Cost of preferred stock: P ps = \$116.95; 10%Q; Par = \$100; F =.05. 10 Use this formula: r ps = D ps P ps (1-F) = 0.1(\$100) \$116.95(1-0.05) = \$10 \$111.10 = 0.090 = 9.0%
Time Line of Preferred 11 2.50 2.50 2.50 0 1 2 r ps =? -111.1 ... \$111.10= D Q r Per = \$2.50 r Per r Per  = \$2.50 \$111.10 = 2.25%; r ps(Nom)  = 2.25%(4) = 9%

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Note: Flotation costs for preferred are significant, so are reflected. Use net price. Preferred dividends are not deductible, so no tax adjustment. Just r ps . Nominal r ps is used. 12
Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm. 13

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Why is yield on preferred lower than r d ? Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.
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