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Cost of Capital
The cost of capital provides a benchmark against which to evaluate investment returns
Projects should not be undertaken unless they return more than the cost of the funds invested in them => the cost of capital.
Rule is equivalent to
Project IRR exceeds the cost of capital Project NPV > 0 when calculated at the cost of capital
Capital Components
A firms Capital Components are
Debt
Borrowed money, either loans or bonds
Common equity
Ownership interest
Preferred stock
A hybrid security, a cross between debt and equity
Capital structure is the mix of the three capital components - generally expressed in percentages
Capital Structure
Target Capital Structure
A mix of components that management considers optimal and strives to maintain
Equity is the riskiest investment, earns the highest return, and has the highest cost Debt is the safest investment, earns the lowest return, and costs the firm least Preferred Stock offers investors intermediate risk and return levels and has a cost between that of equity and debt
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Q: Calculate the WACC for the Zodiac Company given the following information about its capital structure.
Capital Component Debt Preferred Stock Common stock Value $60,000 50,000 90,000 $200,000 Cost 9% 11 14
Example
A: First calculate the capital structure weights based on the values given. For example the weight of debt is $60,000 $200,000 = 30%. Next, each components cost is multiplied by its weight and the results are summed as shown:
Capital Component Debt Preferred Stock Common stock Value $60,000 50,000 90,000 $200,000 Weight 30% 25% 45% 100% Cost 9% 11 14 WACC = 2.70% 2.75% 6.30% 11.75%
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Q: The Wachusett Corporation has the following capital situation. Debt: Two thousand bonds were issued five years ago at a coupon rate of 12%. They had 30-year terms and $1,000 face values. They are now selling to yield 10%.
Example
Preferred stock: Four thousand shares of preferred are outstanding, each of which pays an annual dividend of $7.50. They originally sold to yield 15% of their $50 face value. They're now selling to yield 13%. Equity: Wachusett has 200,000 shares of common stock outstanding, currently selling at $15 per share. Develop Wachusett's market-value-based capital structure.
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A: The market value of each capital component is the current price of each security multiplied by the number outstanding.
The price of Wachusett's bonds in the market must be determined. We know the bonds have 25 years remaining until maturity, pay interest of $120 annually ($60 semi-annually) and are yielding 10% annually (5% semi-annually). Thus, each bond is selling for $1,182.55 in the market, calculated as shown below.
Pb = PMT[PVFAk,n] + FV[PVFk,n] = $60[PVFA5,50] + $1,000[PVF5,50]
Example
= $60(18.2559) + $1,000(0.0872)
= $1,182.55
Because there are 2,000 bonds outstanding, the market value of debt is $1,182.55 x 2,000 = $2,365,100
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The firm's preferred stock represents a perpetuity that pays $7.50 annually and is yielding 13%. Thus, the value of each share of preferred stock is $7.50 / .13 = $57.69 And the total market value of Wachusett's preferred stock is $57.69 x 4,000 = $230,760
Example
Each share of Wachusett's common stock is trading at $15, thus the total market value of the firm's equity is $15 x 200,000 shares = $3,000,000 Next summarize and calculate the component weights: Debt Preferred Equity $2,365,100 230,760 3,000,000 $5,595,860 42.3% 4.1 53.6 100.0%
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Make adjustments for the effects of taxes and transaction costs to arrive at cost to the issuing firm Tax adjustment applies only to debt (Tax rate is T)
Interest is tax deductible to the paying firm Cost of debt = kd (1 T) Debt, the cheapest source, made even cheaper by tax adjustment
Cost of Debt
Example 13.3
Q. Blackstone Inc. has 12% coupon rate bonds outstanding that yield 8% to investors buying them now. Blackstones marginal tax rate including federal and state taxes is 37%. What is Blackstones cost of debt?
Example
A. First notice that kd is the current market yield of 8%, not the coupon rate. To calculate the cost of debt we simply write equation 13.1 and substitute from the information given.
cost of debt = kd(1 - T) = .08(1 - .37) = 5.04%
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Q: The preferred stock of the Francis Corporation was issued several years ago with each share paying 6% of a $100 par value. Flotation costs on new preferred are expected to average 11% of the funds raised. (a) What is the cost of preferred if the return on similar issues is now 9%? (b) Calculate the cost of preferred if shares are selling at $75.
Example
A: (a) and (b) ask the same question in different situations and with different given information. In (a) we have the market return, and in (b) we have the information needed to calculate it . (a) cost of preferred = kp / (1 - f) = 9% / (1 - .11) = 10.1%.
(b)
Example
Q. The return on the Strand Corporations stock is relatively volatile as reflected by the companys beta of 1.8. The return on the S&P 500 is currently 12% and is expected to remain at that level. Treasury bills are yielding 6.5%. Estimate Strands cost of retained earnings. A. Write equation 13.5 and substitute directly, using the return on the S&P 500 as kM and the treasury bill yield as kRF. cost of RE = kX kRF (kM kRF)bX = 6.5% (12% 6.5%)1.8 = 16.4%
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D 0 (1 g) P0 ke g
Solve for ke, which represents expected return.
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Q. Periwinkle Inc. paid a dividend of $1.65 last year and its stock is currently selling for $33.60 a share. The company is expected to grow at 7.5% indefinitely. Estimate the firms cost of retained earnings.
Example
A. Write equation 13.7 and substitute for Periwinkles expected return and the cost of RE.
cost of RE = ke
ke = kd + rpe
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Q. The Carter Companys long-term bonds are currently yielding 12%. Estimate Carters cost of retained earnings.
Example
A. Simply write equation 13.8 and substitute, using 4% for the incremental risk premium. cost of RE = ke kd rPe = 12% + 4% = 16%
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D 0 (1 g) ke g (1 f )P0
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Q. Suppose Periwinkle Inc. of Example 13.6 had to raise capital beyond that available from retained earnings. What would be its cost of equity from new stock if flotation costs were 12% of money raised?
Example
A. Write equation 13.9 and substitute from Example 13.6, including a 12% flotation cost.
D 0 (1 g) g cost of new equity = ke (1 f )P0 $1.65(1.075) .075 (.88)$33.60 .06 .075 13.5%
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$3M / .6 = $5M
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Projects A, B and C should be undertaken because their expected returns exceed the expected costs.
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Baxter Metalworks
MARKET VALUES AND WEIGHTS
Debt: Pb = PMT[PVFAk,n] + FV[PVFk,n] = $45[PVFA6,40] + $1,000[PVF6,40] = $45(15.0463) + $1,000(.0972) = $774.28 Market Value = $774.28 x 5,000 = $3,871,400
Preferred Stock: Dp = $10 kp = .13 Pp = Dp / kp = $10 / .13 = $76.92 Market Value = $76.92 x 20,000 = $1,538,400 Common Equity: Market Value =$12.50 x 1,000,000 = $12,500,000 Market Value Based Weights: $ % Debt $ 3,871,400 21.6% Preferred $ 1,538,400 8.6% Equity $12,500,000 69.8% $17,909,800 100.0%
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Equity - Retained Earnings: CAPM: Cost of RE = kB = kRF + (kM - kRF)bB = 7.0% + (13.5% - 7.0%) 1.8 = 16.1%
Dividend Growth: D0(1+g) Cost of RE = ke = + g. P0 $1.10 (1.065) = + .065 = 15.9% $12.50
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