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1
What types of long-term capital do firms
use?
Capital components are sources of funding that come from
investors categorized into three types.
Common equity (Stocks)
Preferred stock
Long-term debt (Bonds)
Where:
Wd: Weight of Long-term debt
t: Tax Rate
Rs = RFR + MRP X βs
OR
Rs = RFR + (MRR -RFR) X βs
2
OR
Rs = (D1 / P0 ) + g
3
How do you Determine the Weights for
the WACC?
• The weights are the percentages of the firm that will be
financed by each component.
Example:
Suppose the stock price is $50, there are 3 million shares of stock;
the firm has $25 million of preferred stock, and $75 million of
debt.
• Common Equity Value (VCE) = $ 50 (3 million) = $ 150 million.
• Preferred stock Value (VPS) = $ 25 million.
• Long-term debt Value (Vd) = $ 75 million.
• Total value = $ 150 + $ 25 + $ 75 = $ 250 million.
• Common Equity Weight (WCE) = $ 150/$ 250 = 0.6 = % 60
• Preferred stock Weight (WPS) = $ 25/$ 250 = 0.1 = % 10
• Long-term debt Weight (Wd) = $ 75/$ 250 = 0.3 = % 30
Example (1): Given that:
Wd % 40
Rd % 10 VERY
t % 40 IMPORT
WPS % 30 ANT
RPS % 12
WCE % 30
RFR %8
MRR % 18
β 2
4
Example (2): Given that:
Wd % 30
Rd % 15 VERY
t % 35 IMPORT
WPS %0 ANT
WCE % 70
P0 $ 110
g % 10
D0 10 $ / share
Rs = (D1 / P0 ) + g
Rs = (D0 ( 1 + g ) / P0 ) + g
= (10 ( 1 + 0.1 ) / 110 ) + 0.1
= % 20 = 0.2
WACC = Wd Rd (1 - t) + WPS RPS + WCE Rs
= 0.3 X 0.15 X 0.65 + 0 + 0.7 X 0.2
= 0.169 = % 16.9
Note:
• The necessary condition for any project
acceptance :
The project’s rate of return is greater than its cost-- some return is left
over to boost stockholders’ returns.
OR
Project Internal Rate of Return (IRR) > Firm's weighted average cost of
capital (WACC)
This was discussed it in details in Chapter 10 "The Basics of Capital
Budgeting: Evaluating Cash Flows"
• In previous Example:
WACC = % 16.9%, if we have a project with IRR = %20. Decision:
Accept the project
( Profitable Project)