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Unformatted text preview: dgeting techniques.
There are four basic sources of long-term funds for the business firm: longterm debt, preferred stock, common stock, and retained earnings. The right-hand
side of a balance sheet can be used to illustrate these sources:
Assets Stockholders’ equity
Common stock equity
Retained earnings Sources of
long-term funds Although not every firm will use all of these methods of financing, each firm is
expected to have funds from some of these sources in its capital structure.
The specific cost of each source of financing is the after-tax cost of obtaining
the financing today, not the historically based cost reflected by the existing
financing on the firm’s books. Techniques for determining the specific cost of
each source of long-term funds are presented on the following pages. Although
these techniques tend to develop precisely calculated values, the resulting values
are at best rough approximations because of the numerous assumptions and forecasts that underlie them. Although we round calculated costs to the nearest 0.1
percent throughout this chapter, it is not unusual for practicing financial managers to use costs rounded to the nearest 1 percent because these values are merely
estimates. Review Questions
11–1 What is the cost of capital? What role does it play in long-term investment
11–2 Why do we assume that business risk and financial risk are unchanged
when evaluating the cost of capital? Discuss the implications of these
assumptions on the acceptance and financing of new projects.
11–3 Why is the cost of capital measured on an after-tax basis? Why is use of a
weighted average cost of capital rather than the cost of the specific source
of funds recommended?
11–4 You have just been told, “Because we are going to finance this project
with debt, its required rate of return must exceed the cost of debt.” Do
you agree or disagree? Explain.
1. The role of both long-term and short-term financing in supporting both fixed- and current-asset investments is
addressed in Chapter 14. Suffice it to say that long-term funds are at minimum used to finance fixed assets. CHAPTER 11 LG2 The Cost of Capital 473 11.2 The Cost of Long-Term Debt cost of long-term debt, ki
The after-tax cost today of
raising long-term funds through
borrowing. The cost of long-term debt, ki, is the after-tax cost today of raising long-term
funds through borrowing. For convenience, we typically assume that the funds are
raised through the sale of bonds. In addition, as we did in Chapter 6, we assume
that the bonds pay annual (rather than semiannual) interest. Net Proceeds
Funds actually received from the
sale of a security.
The total costs of issuing and
selling a security. EXAMPLE Most corporate long-term debts are incurred through the sale of bonds. The net
proceeds from the sale of a bond, or any security, are the funds that are actually
received from the sale. Flotation costs—the total costs of issuing and selling a
security—reduce the net proceeds from the sale. These costs apply to all public
offerings of securities—debt, preferred stock, and common stock. They include
two components: (1) underwriting costs—compensation earned by investment
bankers for selling the security, and (2) administrative costs—issuer expenses
such as legal, accounting, printing, and other expenses.
Duchess Corporation, a major hardware manufacturer, is contemplating selling
$10 million worth of 20-year, 9% coupon (stated annual interest rate) bonds,
each with a par value of $1,000. Because similar-risk bonds earn returns greater
than 9%, the firm must sell the bonds for $980 to compensate for the lower
coupon interest rate. The flotation costs are 2% of the par value of the bond
(0.02 $1,000), or $20. The net proceeds to the firm from the sale of each bond
are therefore $960 ($980 $20). Before-Tax Cost of Debt
The before-tax cost of debt, kd, for a bond can be obtained in any of three ways:
quotation, calculation, or approximation. Using Cost Quotations
Hint From the issuer’s
perspective, the IRR on a
bond’s cash flows is its cost to
maturity; from the investor’s
perspective, the IRR on a
bond’s cash flows is its yield to
maturity (YTM), as explained
in Chapter 6. These two
measures are conceptually
similarly, although their point
of view is different. When the net proceeds from sale of a bond equal its par value, the before-tax cost
just equals the coupon interest rate. For example, a bond with a 10 percent
coupon interest rate that nets proceeds equal to the bond’s $1,000 par value
would have a before-tax cost, kd, of 10 percent.
A second quotation that is sometimes used is the yield to maturity (YTM) on
a similar-risk bond2 (see Chapter 6). For example, if a similar-risk bond has a
YTM of 9.7 percent, this value can be used as the before-tax cost of debt, kd. Calculating the Cost
This approach finds the before-tax cost of debt by calculating th...
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