Ch09 (1)

# Ch09 (1) - CHAPTER 9 The Cost of Capital 1 Topics in...

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1 CHAPTER 9 The Cost of Capital

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2 Topics in Chapter n Cost of capital components n Debt n Preferred stock n Common equity n WACC n Factors that affect WACC n Adjusting cost of capital for risk
3 Types of Long-term Capital n Long-term debt n Preferred stock n Common equity

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

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6 Cost of Debt n Method 1: Ask an investment banker what the coupon rate would be on new debt. n Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. n Method 3: Find the yield on the company’s debt, if it has any.
7 rd of A 15-year, 12% Semiannual Bond Sells for \$1,153.72? 60 60 + 1,000 60 0 1 2 30 rd = ? -1,153.72 ... 30 -1153.72 60 1000 5.0% × 2 = rd = 10% N I/YR PV FV PMT INPUTS OUTPUT

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8 Component Cost of Debt n Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 – T) rd AT = 10%(1 – 0.40) = 6%. n Use nominal rate.
9 Cost of Preferred Stock: Pps = \$116.95; 10%Q; Par = \$100; F = 5% Use this formula: rps = Dps Pps (1 – F) = 0.1(\$100) \$116.95(1 – 0.05) = \$10 \$111.10 = 0.090 = 9.0%

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10 Time Line of Preferred 2.50 2.50 2.50 0 1 2 rps = ?
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