Professional Documents
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SHORT TERM
MEDIUM TERM
COMPONENT
COST
Cost of Capital
The cost of companys funds
The expected return on a portfolio of all the
companys existing securities
May include cost of debt, cost of preferred stock,
cost of RE, or cost of common stock
Determination of Weights
Book Value (Accounting Numbers) or Market Value?
MV reflects expectations of investors and closely reflects
how a company has to raise new capital.
% of Total
?
?
?
?
Illustration:
At present, Malady Companys balance sheet shows P1 million in short term debt, P1.4
million in long term debt, P0.6 million in preferred stock, and P2 million in common
equity. Market values as determined should have been P1.8 million in short term debt,
P1.5 million in long term debt, P0.4 million in preferred stock, and 1.3 million in
common equity.
Assume that before-tax cost of debt is 5%, cost of preferred stock is 8%, and cost of
common equity is 10%. Further assume that tax rate is 40%. How much is the WACC?
Flotation Costs
Costs associated with the issuance of new securities, such as the
fees paid for the services of an investment banker.
Setting the price of the issue
Selling the issue to the public
They must be accounted for in the computation of WACC,
though they are (unfortunately) frequently ignored.
There may be flotation costs for debt, preferred stock, and new
common stock, but not for retained earnings.
Flotation costs are highest for the issuance of new common
equity though per project cost is fairly small as firms issue
equity infrequently.
Flotation costs are often small and insignificant for the issuance
of debt and preferred stock, hence they are often ignored in
computation for the cost of debt and cost of preferred stock.
Using CAPM
If the rRF = 7%, MRP = 6%, and the firms beta is
1.2, whats the cost of common equity based
upon the CAPM?
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
rs
= D1 / P0 + g
= $4.3995 / $50 + 0.05
= 13.8%
Estimate
14.2%
13.8%
14.0%
14.0%
D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
re
= (D1 / P0 (1 F))+ g
=( $4.3995 / ($50 x 0.85)) + 0.05
= 15.4%
Illustration 1 RE Breakpoint
Maleficent Industries has determined that its optimal capital structure is
20% debt, 30% preferred equity, and 50% common equity. It wants to raise
$50 million to fund a new project. Currently, it has $20 million in net
income and the dividend payout ratio is 50%. How much is the REBP?
Should Maleficent use retained earnings or should it issue new common
equity?
Illustration 2 RE Breakpoint
SSS has a capital structure that consists of 20% equity and 80% debt. The
company expects to report $3 million in net income this year, and 60% of
the net income will be paid out as dividends. How large must the firms
capital budget be this year without it having to issue any new common
stock?
WACC Illustration 2
Anderson Company has four investment opportunities with the following costs (paid at t = 0) and expected returns:
Project
Cost
Expected Return
A
2,000
16.0%
B
3,000
14.5
C
5,000
11.5
D
3,000
9.5
The company has a target capital structure that consists of 40 percent common equity, 40 percent debt, and 20 percent preferred
stock. The company has $1,000 in retained earnings. The company expects its year-end dividend to be $3.00 per share. The
dividend is expected to grow at a constant rate of 5 percent a year. The companys stock price is currently $42.75. If the company
issues new common stock, the company will pay its investment bankers a 10 percent flotation cost.
The company can issue corporate bonds with a yield to maturity of 10 percent. The company is in the 35% tax bracket. How large
can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?
WACC Illustration 3
Valerie Constructions CFO wants to estimate the companys WACC. She has collected the following
information:
The company currently has 20-year bonds outstanding. The bonds have an 8.5 percent annual coupon, a face
value of $1,000, and they currently sell for $945.
The companys stock has a beta = 1.20. The market risk premium equals 5%. The risk-free rate is 6%.
The company has outstanding preferred stock that pays a $2.00 annual dividend. The preferred stock sells for
$25 a share.
The companys tax rate is 40 percent.
The companys capital structure consists of 40 percent long-term debt, 40 percent common equity, and 20
percent preferred stock.
REQUIRED: Compute for the after-tax cost of debt, after-tax cost of preferred stock, after-tax
cost of common equity, and WACC
WACC Illustration 4
Gavan Corp. is a steel manufacturer that finances its operations with 40 percent debt, 10
percent preferred stock, and 50 percent equity. The interest rate on the companys debt is 11
percent. The preferred stock pays an annual dividend of $2 and sells for $20 a share. The
companys common stock trades at $30 a share, and its current dividend of $2 a share is
expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is
15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent.
The company estimates that its WACC is 12.30 percent. Assume that the firm will not have
enough retained earnings to fund the equity portion of its capital budget. What is the
companys tax rate?
Uncontrollable
REQUIRED INVESTMENT
RATE OF RETURN
RISK
$4 million
14.0%
High
$5 million
11.5%
High
$3 million
9.5%
Low
$2 million
9.0%
Average
$6 million
12.5%
High
$5 million
12.5%
Average
$6 million
7.0%
Low
$3 million
11.5%
Low
Required:
Which projects should Ziege accept if it faces no capital constraints?
If Ziege only has the ability to invest a total of $13 million, which projects
should it accept, and what will the firms capital budget be for the next year?
Suppose that Ziege can raise additional funds in order to increase its capital
budget from the level determined in the previous question. However, for
every $5 million of new capital raised by Ziege, the firms WACC is expected
to increase by 1%. If Ziege proceeds to use the same method of risk
adjustment, which projects will it accept, and how much in additional funds
must be raised to complete its capital budget?
Acceptance Region
W ACC
12.0
8.0
Rejection Region
10.5
10.0
9.5
B
L
Risk L
Risk A
Risk H
Risk
Depreciation-generated funds
Privately owned firms
Measurement problems
Adjusting costs of capital for different risk
Capital structure weights
Nothing follows