In either situation the firms action could be

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Unformatted text preview: firm’s action could be detrimental to the firm’s value. By applying the techniques presented in this chapter to estimate the firm’s cost of capital, the financial manager will improve the likelihood that the firm’s long-term decisions are consistent with the firm’s overall goal of maximizing stock price (owner wealth). REVIEW OF LEARNING GOALS Understand the key assumptions that underlie cost of capital, the basic concept of cost of capital, and the specific sources of capital that it includes. The cost of capital is the rate of return that a firm must earn on its investments to maintain its market value and attract needed funds. It is affected by business and financial risks, which are assumed to be unchanged. To capture the interrelatedness of financing, a weighted average cost of capital should be used to find the expected average future cost of funds over the long run. The specific costs of the basic sources of capital (long-term debt, preferred stock, retained earnings, and common stock) can be calculated individually. Calculate the weighted average cost of capital (WACC) and discuss the alternative weighting schemes. The firm’s WACC reflects the expected average future cost of funds over the long run. It can be determined by combining the costs of specific types of capital after weighting each of them by its proportion using historical book or market value weights, or target book or market value weights. The theoretically preferred approach uses target weights based on market values. The key formula for WACC is given in Table 11.4. Determine the cost of long-term debt and the cost of preferred stock. The cost of long-term debt is the after-tax cost today of raising long-term funds through borrowing. Cost quotations, calculation (using either a trial-and-error technique or a financial calculator), or an approximation can be used to find the before-tax cost of debt, which must then be tax-adjusted. The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of preferred stock. The key formulas for the before- and after-tax cost of debt and the cost of preferred stock are given in Table 11.4. Describe the procedures used to determine break points and the weighted marginal cost of capital (WMCC). As the volume of total new financing increases, the costs of the various types of financing will increase, raising the firm’s WACC. The WMCC is the firm’s WACC associated with its next dollar of total new financing. Break points represent the level of total new financing at which the cost of one of the financing components rises, causing an upward shift in the WMCC. The general formula for break points is given in Table 11.4. The WMCC schedule relates the WACC to each level of total new financing. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of common stock. The cost of common stock equity can be calculated by using the constant-growth valuation (Gordon) model or the CAPM. The cost of retained earnings is equal to the cost of common stock equity. An adjustment in the cost of common stock equity to reflect underpricing and flotation costs is necessary to find the cost of new issues of common stock. The key formulas for the cost of common stock equity, the cost of re- Explain how the weighted marginal cost of capital (WMCC) can be used with the investment opportunities schedule (IOS) to make the firm’s financing/investment decisions. The IOS presents a ranking of currently available investments from best (highest return) to worst (lowest return). It is used in combination with the WMCC to find the level of financing/investment that maximizes owner wealth. The firm accepts projects up to the point at which the marginal return on its investment equals its weighted marginal cost of capital. LG1 LG2 LG3 tained earnings, and the cost of new issues of common stock are given in Table 11.4. LG4 LG5 LG6 492 PART 4 Long-Term Financial Decisions TABLE 11.4 Summary of Key Definitions and Formulas for Cost of Capital Definitions of variables AFj b BPj D1 Dp g I ka kd ki km kn kp kr ks n Nd amount of funds available from financing source j at a given cost beta coefficient or measure of nondiversifiable risk break point for financing source j per share dividend expected at the end of year 1 annual preferred stock dividend (in dollars) constant rate of growth in dividends annual interest in dollars weighted average cost of capital before-tax cost of debt after-tax cost of debt required return on the market portfolio cost of a new issue of common stock cost of preferred stock cost of retained earnings required return on common stock number of years to the bond’s maturity net proceeds from the sale of debt (bond) Nn net proceeds from the sale of new common stock net proceeds from the sale of preferred stock value of common stock risk-free rate of return firm’s tax rate proportion of long-term debt in capital structure capital structure proportion (historical or target, stated in decimal form) for financing source j proportion of preferred stock in capital structure proportion of common stock equity in capital structure Np P0 RF T wi wj wp ws Cost of capital formulas Before-tax cost of debt (approximation): $1,000 n I kd After-tax cost of debt: Nd ki [Eq. 11.1] $1,000 2 kd...
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