g if you know that a firms bond is rated AA find the interest rate on newly

G if you know that a firms bond is rated aa find the

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E.g. if you know that a firm’s bond is rated AA, find the interest rate on newly issued AA -rated bonds. Example Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1000 bond. What is the cost of debt? N = 50; PMT = 45; FV = 1000; PV = -908.75 Compute Rate = 5%; YTM = 5(2) = 10% Cost of Preferred Stock Preferred stock generally pays a constant dividend every period. Dividends are expected to be paid every period forever. Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for RP. ? 𝑃 = ? ? 0 Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock? RP = 3 / 25 = 12% The Weighted Average Cost of Capital Notation E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price V = D + E = Market value of the firm Weights w E = E/V = percent financed with equity w D = D/V = percent financed with debt 100% = E/V = D/V Example Suppose you have a market value of equity equal to $500 million and a market value of debt = $475 million. What are the capital structure weights? V = 500 million + 475 million = 975 million w E = E/D = 500 / 975 = .5128 = 51.28% w D = D/V = 475 / 975 = .4872 = 48.72%
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44 Taxes and WACC Since we are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital. o Interest expense reduces our tax liability o This reduction in taxes reduces our cost of debt o After-tax cost of debt = R D (1 T C ) o Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = w E R E + w D R D (1-TC) Divisional and Project Costs of Capital Limitations of WACC WACC is appropriate only when the proposed investment is similar to the firm’s existing activity. o Evaluating investments with risks that are substantially different from those of the overall firm will lead to poor decisions if the WACC is used. o Firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky. Divisional cost of capital o If corporation has more than one line of business, the firm’s overall cost of capital will be a mix of two different costs of capital. o Riskier divisions would tend to have greater returns, resul ting it them becoming the “winner”. o Less glamorous operation might have great profit potential that would end up being ignored. Solutions to Limitations Pure Play Approach The use of a WACC that is unique to a particular project, based on companies in similar lines of businesses. Examine other investments outside the firm that are in the same risk class as the one being considered and use the market-required return on these investments as the discount rate.
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