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Learning Goals
1. Understand the key assumptions, the basic concept, and the specific sources of capital associated with the cost of capital. 2. Determine the cost of long-term debt and the cost of preferred stock. 3. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of commons stock.
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Specific Sources of Capital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt The before-tax cost of debt can be calculated in any one of three ways:
Using cost quotations Calculating the cost Approximating the cost
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Specific Sources of Capital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt
Using Cost Quotations When the net proceeds from the sale of a bond equal its par value, the before-tax cost equals the coupon interest rate. A second quotation that is sometimes used is the yield-to-maturity (YTM) on a similar risk bond.
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Specific Sources of Capital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt
Calculating the Cost This approach finds the before-tax cost of debt by calculating the internal rate of return (IRR). As discussed in earlier in the text, YTM can be calculated using: (a) trial and error, (b) a financial calculator, or (c) a spreadsheet.
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Specific Sources of Capital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt
Calculating the Cost
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Specific Sources of Capital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt
Approximating the Cost
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Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate:
ri = 9.4% (1-.40) = 5.6%
This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.
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Duchess Corporation is contemplating the issuance of a 10% preferred stock that is expected to sell for its $87-per share value. The cost of issuing and selling the stock is expected to be $5 per share. The dividend is $8.70 (10% x $87). The net proceeds price (Np) is $82 ($87 - $5). rP = DP/Np = $8.70/$82 = 10.6%
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We can also estimate the cost of common equity using the CAPM:
rE = rF + b(rM - rF).
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Specific Sources of Capital: The Cost of Common Stock (cont.) The CAPM differs from dividend valuation models in that it explicitly considers the firms risk as reflected in beta. On the other hand, the dividend valuation model does not explicitly consider risk. Dividend valuation models use the market price (P0) as a reflection of the expected risk-return preference of investors in the marketplace.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Specific Sources of Capital: The Cost of Common Stock (cont.) Cost of Retained Earnings (rE)
Constant Dividend Growth Model
rs = D1/P0 + g For example, assume a firm has just paid a dividend of $2.50 per share, expects dividends to grow at 10% indefinitely, and is currently selling for $50.00 per share. First, D1 = $2.50(1+.10) = $2.75, and rS = ($2.75/$50.00) + .10 = 15.5%.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Specific Sources of Capital: The Cost of Common Stock (cont.) Cost of Retained Earnings (rE)
The previous example indicates that our estimate of the cost of retained earnings is somewhere between 15.5% and 15.8%. At this point, we could either choose one or the other estimate or average the two. Using some managerial judgment and preferring to err on the high side, we will use 15.8% as our final estimate of the cost of retained earnings.
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Specific Sources of Capital: The Cost of Common Stock (cont.) Cost of New Equity (rn)
Constant Dividend Growth Model
rn = = D1/Nn - g Continuing with the previous example, how much would it cost the firm to raise new equity if flotation costs amount to $4.00 per share? rn = [$2.75/($50.00 - $4.00)] + .10 = 15.97% or 16%.
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This implies that the firm can fund up to $4 million of new investment before it is forced to issue new equity and $2.5 million of new investment before it is forced to raise more expensive debt. Given this information, we may calculate the WMCC as follows:
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11.25% 11.13%
$2.5
Copyright 2009 Pearson Prentice Hall. All rights reserved.
$4.0
A B
WMCC
11.13% 11.0%
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Table 11.4 Summary of Key Definitions and Formulas for Cost of Capital (cont.)
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Table 11.4 Summary of Key Definitions and Formulas for Cost of Capital
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Table 11.1 Calculation of the Weighted Average Cost of Capital for Duchess Corporation
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Table 11.2 Weighted Average Cost of Capital for Ranges of Total New Financing for Duchess Corporation
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