What sources of long-term capital

do firms use?
Long-Term Capital
Capital
Long-Term

Long-Term Debt
Debt Preferred
Preferred Stock
Stock Common
Common Stock
Stock
Long-Term

Retained Earnings
Earnings
Retained

New Common
Common Stock
Stock
New

Cost of Capital Terms:

Kd:

Kd(1-T):

Kps:
Ks:
WACC:

Cost of Debt:
Investors demand Kd
After tax cost of Debt:

Revenues
-Expenses
-Depreciation
EBIT
-Interest expense
EBT
-Taxes
EAT (NI)

Cost of Preferred stock:

Cost of Retained Earnings:

CAPM:

Bond-Yield-plus-risk-Premium approach:

DCF:

g = (Retention rate)(ROE) =

Cost of Newly issued Common Stock (External equity):

Ke =

Assume a firm has $100,000 in assets financed with 100%

equity, it earns 15% on assets but pays out all earnings.
The firm has 1,000 shares of stock, therefore Po = $100.
EPS = DPS = 15% * 100 = $15
Now suppose our firm wants to issue an additional 1,000
shares of stock. It can sell new stock at the current price of
$100/sh, with a 10% float cost going to the banker.
Firm gets:

Total assets:

$return:

New EPS:

New Po:

Ke : = D1/Po(1-F) + g

How are the weights determined?

WACC = wdkd(1-T) + wpkp + wcks

Use accounting numbers or market value (book vs. market
weights)?
Use actual numbers or target capital structure?

MCC: Marginal Cost of Capital:

Retained earnings break point:

Assume we only have $50,000 in retained earnings available, and that we
want to keep our cap-structure

(debt 40%, Pref 10%, equity 50%)

How many dollars of capital can we raise before
We want to raise $200,000.
So our initial coast of capital is
.4(Kd)(1-T) + .1(Kps) + .5(Kre)
.4(8%((1-.4) + .1 (10%) + .5(13.5%)
but we will run out of retained earnings at some point.
Equity = 50% of our capital = .5($200,000) = $100,000 total needed
But we only have $50,000 in RE
$50,000 = .5(BP)

After that we will have to issue now stock/equity if we wish to maintain our
capital structure of 40/10/50.
New equity costs more due to float costs: 14.2%
WACC = .4(Kd)(1-T) + .1(Kd) + .5(Ke)
.4(8%)(1-.4) + .1(10%) + .5(14.2%)

MCC Schedule:
WACC

Factors the effect cost of capital:

Interest rates
Tax rates

Capital Structure Policy:

Dividend Policy:

Investment Policy: In what type of projects will we be investing?

How do we use the MCC in deciding which projects to invest.

1. Look at what projects are available.
2. Estimate cash flow from each project.
3. Use TVM to see if PV is positive.
4. If PV is positive, what is the Expected rate of return.
Rank all (+) projects in order of ERR( IRR)
Graph amounts and rates on the MCC schedule.

Should the company use the composite WACC as the hurdle rate for
each of its projects?

NO! The composite WACC reflects the risk of an average project

undertaken by the firm. Therefore, the WACC only represents
the hurdle rate for a typical project with average risk.

Different projects have different risks. The projects WACC

should be adjusted to reflect the projects risk.

Risk and the Cost of Capital

Rate of Return
(%)

Acceptance Region
WACC

12.0

8.0

Rejection Region

10.5
10.0
9.5

B
L

RiskL

RiskA

RiskH

Risk