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CHAPTER 9
The Cost of Capital
Long-Term
Capital
Long-Term
Debt
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
Preferred
Stock
Common
Stock
Retained
Earnings
New Common
Stock
9-2
Capital Components
9-3
9-4
T= tax rate
9-6
of financing.
9-7
(2)
(3)
(4)
Product of (2)
and (3)
Debt
wd
rd (1-T)
wdrd (1-T)
Preferred Stock
wps
rp
wpsrp
Common Stock
wcs
rs
wcsrs
Sum=
Market Value
A-T Cost of
Weights
Financing
9-8
100%
9-9
9-10
9-12
(2)
Source of
Capital
9-13
(4)
=
Product of (2)
and (3)
Debt
0.250
0.060
0.01500
Preferred Stock
0.125
0.100
0.01250
Common Stock
0.625
0.150
Sum=
100%
0.09375
0.12125
STEP 4: Analyze
Templetons CFO estimated that the firm's WACC is 12.125%, which lies
within the range between the highest cost of source of capital (common
stock at 15%) and the lowest (debt at 6%).
9-14
(3)
Market Value
A-T Cost of
Weights
Financing
9-16
$1,153.72 =
$60
$1,000
{1 (1 + rd / 2) 215 } +
rd / 2
(1 + rd / 2) 215
rd = 10%
9-18
CI
M
{1 (1 + rd ) n } +
rd
(1 + rd )n
($1,000 $50) =
$100
$1,000
{1 (1 + rd ) 10 } +
rd
(1 + rd )10
= 10.83%
(VB F) =
CI
M
{1 (1 + rd ) n } +
rd
(1 + rd )n
$50
$1000
{1 (1 + rd ) 10 } +
= 0.0638
rd
(1 + rd )10
Thus, A - T cost of debt (YTM) = rd (1 - T)
$900 =
9-19
9-20
Solution:
$120 / 2
$1000
$1153.7 =
{1 (1 + rd / 2) 30 } +
rd / 2
(1 + rd / 2)30
Annualized rd = 5% 2 = 10%
rP = DPs / P0
9-21
9-22
rp = $10 / $111.10= 9%
9-23
rps =
Dps
Nps
Preferred stock:
The cost of preferred
stock if PPs =
$113.10; dividend =
10% paid quarterly,
Par = $100; flotation
cost (F) = $2, will
be:
Preferred stock:
The Cost of preferred
stock if PPs =
$116.95; dividend =
10% paid quarterly,
Par = $100; flotation
cost (F) = $5%, will
be
Dps
Pps - FlotationCost)
$10
$113.10 - $2
= 0.090 = 9.00%
=
Dps
Pps (1 - F)
0.1($100)
$116.95(1 - 0.05)
$10
=
$111.10
= 0.090 = 9.00%
=
9-25
9-26
9-27
Recall, that the firms tax rate is 40%, and its BT costs of debt and preferred stock are r d =
10% and rps = 9%, respectively.
9-28
9-29
DGM:
Or
CAPM:
rs = D1 / P0 + g
rs = D1 / Ns+ g
rs =
When g is constant
rs =
9-32
D1
+g
Ns
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)= $4.3995
rs = D1 / P0 + g
= $4.3995 / $50 + 0.05 = 13.8%
$6
+ 6%
$80 - $4
= 8.3% + 6% = 14.3%
9-33
9-34
Solution: rs = kd + RP
9-35
Estimate
14.2%
13.8%
14.0%
14.0%
9-38
rr = rs =
D1
+g
P0
$6
+ 6%
$80
= 7.5% + 6% = 13.5%
=
9-39
9-40
re =
D 0 (1 + g)
+g
P0 (1 - F)
$4.19(1.05)
+ 5.0%
$50(1 - 0.15)
$4.3995
+ 5.0%
$42.50
= 15.4%
=
9-41
9-42
Flotation costs
WACC
9-43
Market conditions
9-44
9-45
Acceptance Region
W ACC
12.0
Rejection Region
10.5
10.0
9.5
8.0
9-46
Risk L
Risk A
Risk H
Stand-alone risk
Corporate risk
Market risk
Risk
9-47
9-48
Depreciation-generated funds
Measurement problems
9-49
9-50
9-51
rs
WACC = wd rd ( 1 T ) + wc rs
= 0.4 (12%)(0.6) + 0.6 (17.2%) =13.2%
9-52
Exercise Problem:9-1
David Ortiz Motors has a target capital structure
of 40% debt and 60% equity. The yield to
maturity on the companys outstanding bonds is
9%, and the companys tax rate is 40%. Ortizs
CFO has calculated the companys WACC as
9.96%. What is the companys cost of equity
capital?
Solution:
0.0996 = 0.6(requity ) + 0.4(1 - 0.4)(0.09)
requity = 13%
9-54
Exercise Problem:9-2
Exercise Problem:9-7
A companys 6% coupon rate, semiannual
payment, $1,000 par value bond which matures
in 30 years sells at a price of $515.16. The
companys federal-plus-state tax rate is 40%.
What is the firms component cost of debt for
purposes of calculating the WACC?
Solution:
515.16 =
3.8
=
= 8%
50(1 - 0.05)
30
[1
i/2
(1 + i / 2)
60
1,000
(1 + i / 2)60
i = 12%
Cost
9-55
of
debt = 12%(1
0.4) = 7.2%
9-56
10