# 40 x 60 240 cost of pref 10 x 119 119 cost of

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Unformatted text preview: is 40% debt, 10% preferred and 50% common equity. WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Preferred .10 x 11.9% = 1.19% + Cost of Int. Equity .50 x 15.5% = 7.75% 1.00 = 11.34% 11.34% Weighted Average Cost of Capital If using new common stock (External Equity) to finance the common stock portion: WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks) Then we must use the cost of stock adjusted for the Flotation costs WACC = Cost of Debt .40 x 6.0% = 2.40% + Cost of Pref .10 x 11.9% = 1.19% + Cost of Ext. Eq. .50 x 16.25% = 8.13% = 11.72% 11.72 Marginal Cost of Capital Gallagher’s weighted average cost will change if one component cost of capital changes. This may occur when a firm raises a particularly large amount of capital such that investors think that the firm is riskier. The WACC of the next dollar of capital raised is called the marginal cost of capital. 24 24 Spending Capital Money The assumption is that the capital money is spent in direct proportion to the optimal capital structure. So, if we spend \$100,000, it would be in the following proportions: Capital Structure Spend Debt 40% 40,000 Preferred 10% 10,000 Common 50% 50,000 (Buckets) Total 100,000 Calculating the Breakpoint Assume now that Gallagher Corporation has \$100,000 in retained earnings with which to finance its capital budget. We can calculate the point at which they will need to issue new equity since we know that Gallagher’s desired capital structure calls for 50% common equity. Breakpoint = Available Retained Earnings Equity Percentage of Total 26 26 Calculating the Breakpoint Breakpoint = (\$100,000)/.5 = \$200,000 What this means is that once we spend \$200,000 in total on capital projects, we will have used up our retained earnings of \$100,000 (internal equity). Therefore, if we spend over \$200,000, we will need additional financing from the issue of new shares of stock since 50% of our spending must come from Equity. The cost of issuing new shares is greater than internal equity due to flotation costs Making Decisions Using MCC Weighted Cost of Capital Marginal weighted cost of capital curve: 13% 11.72% 12% 11.34% 11% 10% 0 Using internal Using internal common equity common equity 100,000 Using new Using new common equity common equity 200,000 Total Financing 300,000 400,000 28 28 Making Decisions Using MCC Graph IRRs of potential projects Weighted Cost of Capital Marginal weighted cost of capital curve: 12% 11% Project 1 IRR = IRR 12.4% 12.4% 10% Project 2 IRR = IRR 12.1% 12.1% Project 3 IRR = 11.5% 9% 0 100,000 200,000 Total Financing 300,000 400,000 29 29 Making Decisions Using MCC Graph IRRs of potential projects Graph MCC Curve Weighted Cost of Capital Marginal weighted cost of capital curve: 11.72% 12% 11.34% 11% Project 1 IRR = IRR 12.4% 12.4% 10% Project 2 IRR = IRR 12.1% 12.1% Project 3 IRR = 11.5% 9% 0 100,000 200,000 Total Financing 300,000 400,000 30 30 Making Decisions Using MCC Graph IRRs of potential projects Graph MCC Curve Choose projects whose IRR is above the weighted marginal cost of capital Weighted Cost of Capital Marginal weighted cost of capital curve: 11.72% 12% 11.34% 11% Project 1 IRR = IRR 12.4% 12.4% 10% Project 2 IRR = IRR 12.1% 12.1% Project 3 IRR = 11.5% Accept Projects #1 & #2 9% 0 100,000 200,000 Total Financing 300,000 400,000 31 31 MCC and Capital Budgeting Decisons See pages 250 – 256 Calculate the breakpoints Calculate the new MCC’s Plot MCC’s and Investment Projects See Figures 9­5 and 9­6 for results Do all the Self­test problems before doing the homework...
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## This document was uploaded on 02/19/2014.

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