Example in earlier examples we found the costs of the

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Unformatted text preview: ll be financed using retained earnings, kr , or new common stock, kn. EXAMPLE In earlier examples, we found the costs of the various types of capital for Duchess Corporation to be as follows: Cost of debt, ki Cost of preferred stock, kp Cost of retained earnings, kr Cost of new common stock, kn 5.6% 10.6% 13.0% 14.0% CHAPTER 11 Hint For computational convenience, the financing proportion weights are listed in decimal form in column 1 and the specific costs are shown in percentage terms in column 2. TABLE 11.1 The Cost of Capital 483 Calculation of the Weighted Average Cost of Capital for Duchess Corporation Cost (2) Weighted cost [(1) (2)] (3) 5.6% 2.2% Source of capital Weight (1) Long-term debt 0.40 Preferred stock 0.10 10.6 Common stock equity 0.50 13.0 Totals 1.00 1.1 6.5 9.8% Weighted average cost of capital 9.8% The company uses the following weights in calculating its weighted average cost of capital: Source of capital Weight Long-term debt 40% Preferred stock 10 Common stock equity Total 50 100% Because the firm expects to have a sizable amount of retained earnings available ($300,000), it plans to use its cost of retained earnings, kr , as the cost of common stock equity. Duchess Corporation’s weighted average cost of capital is calculated in Table 11.1. The resulting weighted average cost of capital for Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all projects that will earn a return greater than 9.8%. Weighting Schemes Weights can be calculated on the basis of either book value or market value and using either historical or target proportions. book value weights Weights that use accounting values to measure the proportion of each type of capital in the firm’s financial structure. market value weights Weights that use market values to measure the proportion of each type of capital in the firm’s financial structure. Book Value Versus Market Value Book value weights use accounting values to measure the proportion of each type of capital in the firm’s financial structure. Market value weights measure the proportion of each type of capital at its market value. Market value weights are appealing, because the market values of securities closely approximate the actual dollars to be received from their sale. Moreover, because the costs of the various types of capital are calculated by using prevailing market prices, it seems reasonable to use market value weights. In addition, the long-term investment cash 484 PART 4 Long-Term Financial Decisions flows to which the cost of capital is applied are estimated in terms of current as well as future market values. Market value weights are clearly preferred over book value weights. Historical Versus Target historical weights Either book or market value weights based on actual capital structure proportions. target weights Either book or market value weights based on desired capital structure proportions. Historical weights can be either book or market value weights based on actual capital structure proportions. For example, past or current book value proportions would constitute a form of historical weighting, as would past or current market value proportions. Such a weighting scheme would therefore be based on real—rather than desired—proportions. Target weights, which can also be based on either book or market values, reflect the firm’s desired capital structure proportions. Firms using target weights establish such proportions on the basis of the “optimal” capital structure they wish to achieve. (The development of these proportions and the optimal structure are discussed in detail in Chapter 12.) When one considers the somewhat approximate nature of the calculation of weighted average cost of capital, the choice of weights may not be critical. However, from a strictly theoretical point of view, the preferred weighting scheme is target market value proportions, and these are assumed throughout this chapter. Review Questions 11–11 What is the weighted average cost of capital (WACC), and how is it calculated? 11–12 Describe the logic underlying the use of target capital structure weights, and compare and contrast this approach with the use of historical weights. What is the preferred weighting scheme? LG5 LG6 11.6 The Marginal Cost and Investment Decisions The firm’s weighted average cost of capital is a key input to the investment decision-making process. As demonstrated earlier in the chapter, the firm should make only those investments for which the expected return is greater than the weighted average cost of capital. Of course, at any given time, the firm’s financing costs and investment returns will be affected by the volume of financing and investment undertaken. The weighted marginal cost of capital and the investment opportunities schedule are mechanisms whereby financing and investment decisions can be made simultaneously. The Weighted Marginal Cost of Capital (WMCC) The weighted average cost of capital may vary over time, dependi...
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This document was uploaded on 01/19/2014.

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