Professional Documents
Culture Documents
Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk
10-1
Long-Term Debt
Preferred Stock
Common Equity
Retained Earnings
The weighted average of the component costs of debt, preferred stock and common equity.
The ws are all weights of different components. The rs are all the rate of return to be paid to the investors. T is the tax rate.
9-3
Should our analysis focus on historical (embedded) costs or new (marginal) costs?
The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC).
9-4
Cost of debt, rd
The quoted interest rate the firm must pay on new debt. After tax cost of debt is used, rd(1-T). As interest is tax-deductible, the firm is getting a tax advantage by taking on debt. Thus the tax advantage is taken into account while calculating the cost of debt.
The rate of return investors require on firms preferred stocks. rp = Dp/Pp Preferred dividends are not taxdeductible, so no tax adjustments necessary.
9-6
Cost of Equity, rs
Cost of retained earnings = opportunity cost of investing in more stocks i.e. required rate of return Cost of common stocks = required rate of return and floating cost of the firms shares.
9-7
Methods of calculating rs
CAPM approach, r = rRF + (rM + rRF)b Bond yield plus risk premium of 3% to 5%.
Dividend yield plus expected growth rate, r = (D1/P0) + g Final estimate of rs is the average of all the alternative estimates 9-8
Flotation costs
The percentage cost of issuing new common stock given to investment bankers or brokers. It is usually adjusted with the required rate of return to find the cost of equity. Flotation costs depend on the risk of the firm and the type of capital being raised. The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small. We will frequently ignore flotation costs when calculating the WACC.
9-9
The amount that must be added to estimated rs to account for floatation cost.
9-10
Interest rates in the economy General level of stock prices Tax rates Capital Structure Dividend payout ratio Capital Budgeting decisions
9-11