Chap. 11

The cost of Capital

MA0N0239Yu Muramatsu

The rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock

The rate of return required by the market suppliers of capital to attract their funds to the firm

Cost of capital

1.Business Risk the firm’s acceptance of a given project

does not affect its ability to meet operating cost2.Financial Risk projects are financed in such a way that the

firm’s ability to meet required financing cost is unchanged

3.After-tax costs are considered relevant measured on an after-tax basis

Key assumptions

Because of terrorist attack in Sep. 2001 and economic difficulties, UAL lost $2.14 billion in 2001.

UAL Corporation filed for Chapter 11 bankruptcy protection in Dec. 2002.

United Airlines

RestructuringUAL received offers of

subscription for more than twice the capital necessary to support the $3 billion it sought.

UAL was able to reduce its financing costs by 75 basis points(0.75%)

United Airlines (Cont.)

UAL was able to restructure its $3 billion debt

Because of oversubscription of the refinancing, UAL made its financing costs lower

The new loan was set at 200 basis points (2.00%) over LIBOR , a reduction of 175 basis points (1.75%) from the original financing cost

The lower pricing is expected to result in net pre-tax savings of approximately $70 million per year

United Airlines (Cont.)

UAL was able to meet its capital needs primarily from operating activities and the issuance of debt

Companies will strive to meet some desired mix of debt and equity capital financing to raise its capital

Conclusion

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