Convertible securities warrant right to buy shares

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CONVERTIBLE SECURITIES Warrant: right to buy shares from company at a stipulated price before a set date 32. Companies often issue warrants and bonds in a package Convertible Bond: bond that holder may exchange for a specified amount of another security 33. CB sells at higher price than regular because it’s company equity dilution! CHAPTER 13 – COST OF CAPITAL* 1. GEOTHERMAL’S COST OF CAPITAL If COC < Expected Return, expansion is good as it will generate net value for company and share holders Capital Structure: a firm’s mix of debt and equity financing Company’s COC is just a weighted-average of returns on debt and equity, with weights depending on relative market values of the two securities Page 36 of 42
Fundamentals of Corporate Finance (Brealey) Weiting Xu Professor: Andreanne Tremblay Chapter Reading Notes FINE 2000 2. THE WEIGHTED-AVERAGE COST OF CAPITAL - Company COC is minimum acceptable rate of return when firm expands by investing in average-risk projects - The expected ROR on investments in financial markets determine COC for company as a whole Calculating Company Cost of Capital as a Weighted Average Company cost of capital is a weighted average of returns demanded by debt and equity investors Weighted average is expected rate of return investors would demand on a portfolio of all the firm’s outstand securities - Ignoring taxes: Company COC = Weighted average of debt and equity returns e.g. Geothermal’s capital structure is 30% debt and 70% equity; required returns are 8% and 14% respectively - To find return that is needed on assets, divide income by investment Expected return demanded by investors in Geothermal’s assets amount to 12.3% Use Market Weights, Not Book Weights - Company COC is expected ROR that investors demand from company’s assets and operations COC must be based on what investors are actually willing to pay for company’s outstanding securities (i.e. based on securities’ market values) - Book values, while useful for many other purposes, measure only net cumulative historical outlays; they don’t generally measure market values accurately Taxes and Weighted- Average Cost of Capital - You need to discount the CF after tax because after-tax CF are relevant project cash flows - Interest payments on debt are deducted from income before tax is calculated e.g. Geothermal’s debt is , , gov’t bears 35% of the cost of interest payments After-tax cost of debt = (1 – tax rate) x pretax cost = (1 – T c ) x = (1 – 35%) x 8% = 5.2% Weighted-average cost of capital (WACC): expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments WACC = [] + [] What if there are three (or more) sources of financing? - Everything remains the same, just add in the extra weighted average!

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