3. the Cost of Capital
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Weighted Average Cost of Capital (WACC)
Capital Structure
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Cost of Capital
Cost of Capital - The return the firm’s investors could expect to
earn if they invested in securities with comparable degrees of
risk.
Capital Structure - The firm’s mix of long term financing and
equity financing.
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Cost of Capital
Example - Geothermal Inc. has the following structure. Given that
geothermal pays 8% for debt and 14% for equity, what is the Company
Cost of Capital?
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Cost of Capital
Example - Geothermal Inc. has the following structure. Given that
geothermal pays 8% for debt and 14% for equity, what is the Company
Cost of Capital?
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reserved
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Cost of Capital
Example - Geothermal Inc. has the following structure. Given that
geothermal pays 8% for debt and 14% for equity, what is the Company
Cost of Capital?
Interest is tax deductible. Given a 35% tax rate, debt only costs
us 5.2% (i.e. 8 % x .65).
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WACC
Weighted Average Cost of Capital (WACC) - The expected rate of
return on a portfolio of all the firm’s securities.
Company cost of capital = Weighted average of debt and equity
returns.
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Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a proportion of the
firm’s market value.
2. Determine the required rate of return on each security.
3. Calculate a weighted average of these required returns.
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WACC
Taxes are an important consideration in the company cost of capital
because interest payments are deducted from income before tax is
calculated.
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WACC
Example - Executive Fruit has issued debt, preferred stock and
common stock. The market value of these securities are $4mil,
$2mil, and $6mil, respectively. The required returns are 6%, 12%,
and 18%, respectively.
Q: Determine the WACC for Executive Fruit, Inc.
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Step 2
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Measuring Capital Structure
In estimating WACC, do not use the Book Value of securities.
In estimating WACC, use the Market Value of the securities.
Book Values often do not represent the true market value of a
firm’s securities.
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Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted
at the current interest rate.
Market Value of Equity - Market price per share multiplied by the
number of outstanding shares.
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Perpetuity Growth Model =
solve for re
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Price of Preferred Stock =
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Irwin/McGraw Hill
Flotation Costs
The cost of implementing any financing decision must be
incorporated into the cash flows of the project being
evaluated.
Only the incremental costs of financing should be included.
This is sometimes called Adjusted Present Value.
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Problems
Q1) Cost of Debt. Micro Spinoffs, Inc., issued 20-year debt a year
ago at par value with a coupon rate of 8 percent, paid annually.
Today, the debt is selling at $1,050. If the firm’s tax bracket is
35 percent, what is its after-tax cost of debt?
Q2) Cost of Preferred Stock. Micro Spinoffs also has preferred
stock outstanding. The stock pays a dividend of $4 per share, and
the stock sells for $40. What is the cost of preferred stock?
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Problems
Q3) Calculating WACC. Suppose Micro Spinoffs’s cost of equity is 12
percent. What is its WACC if equity is 50 percent, preferred stock
is 20 percent, and debt is 30 percent of total capital?
Q4) Calculating WACC. Reactive Industries has the following capital
structure. Its corporate tax rate is 35 percent. What is its
WACC?
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Problems
Q5 Calculating WACC. Find the WACC of William Tell Computers. The
total book value of the firm’s equity is $10 million; book value
per share is $20. The stock sells for a price of $30 per share, and
the cost of equity is 15 percent. The firm’s bonds have a par value
of $5 million and sell at a price of 110 percent of par. The yield
to maturity on the bonds is 9 percent, and the firm’s tax rate is
40 percent.
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Problems
Long street communications Inc (LCI) has the following capital
structure, which it considers to be optimal:
Debt = 25%
Preferred Stocks = 15%
Common stocks = 60%
LCI’s net income expected this year is $ 17,142.86, its established
dividend payout ratio is 30 percent, its tax rate is 40 percent and
investors expect earning and dividends to grow at a constant rate
of 9 percent in the future. LCI paid a dividend of $ 3.60 per share
last year and its stock currently sells at a price of $ 60 per
share. Treasury bonds yield 11 percent and average stock beta has a
14 percent expected rate of return and LCI’s beta is 1.51. These
terms will apply to new offerings:
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Problems
Common: New common stock would have a floating cost of 10
percent.
Preferred: New preferred could be sold to the public at a price of
$ 100 per share with the dividend of $11, Floating cost of $ 5
would be incurred.
Debt: New debt could be sold at an interest rate of 12
percent.
Find the component cost debt, preferred stock, retained earnings
and new common stocks?
What is the WACC?