5 views

Uploaded by Abdussalam Al-hakimi Mohd Tahir

- Capital Structure,Cost of Capital & Valuation
- 07 b Cost of Capital
- Chapter 15 Capital Structure and Leverage
- Cost of Capital(Final)
- Lecture 3
- Corporate Finance Quiz Helper
- New Microsoft Word Document
- Final_version_TPgroup5_philips_Lighting
- Fm unit III
- Capital Structure 1
- marriottcase-160802220034.docx
- MOP-Capital theory Assignment-020310
- Chapter 21 - Capital Structure Decisions
- Finance Chapter 9
- Capital Structure
- FinGame 5.0 Participants Ch03
- Advanced Tech Questions
- Cost of Capital
- Cost of Capital
- GST – Practice Pointer Issues

You are on page 1of 8

COST OF CAPITAL

CHAPTER 12 QUIZ

CHAPTER ORGANIZATION

The appropriate discount rate to use when evaluating a capital budgeting project depends largely on the risk of the

project. The new project will have a positive NPV only if its return exceeds what the financial markets offer on

investments of similar risk. We called this minimum required return the cost of capital associated with the project. The

weighted average cost of capital (WACC) is the cost of capital for the firm as a whole, and it can be interpreted as the

required return on the overall firm. In discussing the WACC, we will recognize the fact that a firm will normally raise

capital in a variety of forms and that these different forms of capital may have different costs associated with them.

Taxes are an important consideration in determining the required return on an investment, because we are always

interested in valuing the aftertax cash flows from a project. We will therefore discuss how to incorporate taxes

explicitly into our estimates of the cost of capital.

good capital budgeting decisions neither the NPV rule nor the IRR rule can be implemented without

knowledge of the appropriate discount rate.

financing decisions the optimal/target capital structure minimizes the cost of capital.

operating decisions cost of capital is used by regulatory agencies in order to determine the fair return in

some regulated industries (e.g. electric utilities.

Required Return versus Cost of Capital: Cost of capital, required return, and appropriate discount rate are

different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative

financial market investments of the same systematic risk. Required return is from an investors point of

view; cost of capital is the same return from the firms point of view; appropriate discount rate is the

same return used in a PV calculation.

The cost of capital depends primarily on the use of the funds, not the source.

The investment decisions of the firm are separate from the financing decisions.

Financial Policy and Cost of Capital: The particular mixture of debt and equity a firm chooses to employ is

referred to as its capital structure; this is a managerial variable. For now, we will take the firm's financial

policy as given. In particular, we will assume that the firm has a fixed debt-equity ratio that it maintains.

This ratio reflects the firm's target or optimal capital structure. Given that a firm uses both debt and equity

capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and its

stockholders. In other words, a firm's cost of capital will reflect both its cost of debt capital and its cost of

equity capital.

12.2 The Cost of Equity: The firm's overall cost of equity is difficult to estimate since there is no way of directly

observing the return that the firm's equity investors require on their investment.

P0 = D0(1 + g) / (RE g) = D1 / RE g.

RE = (D1 / P0) + g ,

which equals the dividend yield plus the growth rate (capital gains yield).

Of the required data, only g is not directly observable [Note: D1 = D0(1 + g)]. The deficiencies of this

approach are (1) it assumes that dividends grow at a constant rate; (2) the value of g must be estimated and

forecasting errors impact the value of RE; and (3) risk is not explicitly considered.

To use the dividend growth model, we must come up with an estimate for g, the growth rate. There are

essentially two ways of doing this: (1) use historical growth rates or (2) use analysts' forecasts of future

growth rates. Analysts' forecasts are available from a variety of sources.

Alternatively, we might observe dividends for the previous, say, five years, calculate the year-to-year growth

rates, and average them. For example, suppose we observe the following for some company:

2004 $4.00 - -

2005 $4.40 $.40 10.00%

2006 $4.75 $.35 7.95%

2007 $5.25 $.50 10.53%

2008 $5.65 $.40 7.62%

The Boos Co. just issued a dividend of $2.40 per share on its common stock. The company is expected to maintain a

constant 6 percent growth rate in its dividends indefinitely. If the stock sells for $48 a share, what is the company's cost

of equity?

With the information given, we can find the cost of equity, using the dividend growth model. Using this model, the cost

of equity is:

The SML Approach - The required or expected return on a risky investment depends on three things:

(2) The market risk premium, E(RM) Rf

(3) The systematic risk of the asset relative to average, which we called its beta coefficient,

Using the SML, we can write the expected return on the company's equity, E(RE), as:

or simply

RE = Rf + E(RM Rf)

Betas are widely available and T-bill rates are often used for Rf. The expected market risk premium, E(RM) Rf,

is the more difficult number to come up with. One of the problems is that we really do need an expectation, but

we only have past information, and market risk premiums do vary through time. Early in 2000, Federal Reserve

Chairman, Alan Greenspan, indicated that part of his concern with the current state of the U.S. stock markets is

the reduction in the market risk premium. He felt that investors were either becoming less risk averse, or they

did not truly understand the risk they were taking by investing in the stock. Nonetheless, the historical average

is often used as an estimate for the expected market risk premium.

- This approach explicitly adjusts for risk in a fashion that is consistent with capital market history.

- It is applicable to virtually all publicly-traded stocks for which the value of can be determined.

- The main disadvantage is that the past is not a perfect predictor of the future, and both beta and the market risk

premium vary through time.

Iceberg Corporation's common stock has a beta of 1.30. If the risk-free rate is 5 percent and the expected return on the

market is 13 percent, what is the company's cost of equity capital?

Here we have information to calculate the cost of equity, using the CAPM. The cost of equity is:

Prepared by Jim Keys 3

12.3 The Costs of Debt and Preferred Stock

The Cost of Debt - The cost of debt is the return that the firm's creditors demand on new borrowing.

Unlike a firm's cost of equity, its cost of debt can normally be observed either directly or indirectly, because the

cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in

the financial markets. For example, if the firm already has bonds outstanding, then the yield to maturity on

those bonds is the market-required rate on the firm's debt.

Alternatively, if we knew that the firm's bonds were rated, say, AA, then we could simply find out what the

interest rate on newly issued AA-rated bonds was. Either way, there is no need to actually estimate a beta for the

debt since we can directly observe the rate we want to know.

The coupon rate on the firm's outstanding debt is irrelevant here. That just tells us roughly what the firm's cost

of debt was back when the bonds were issued, not what the cost of debt is today. This is why we have to look at

the yield on the debt in today's marketplace. For consistency with our other notation, we will use the symbol RD

for the cost of debt.

ICU Window, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with seven years to

maturity that is quoted at 93 percent of face value. The issue makes semiannual payments and has an embedded cost of

5.6 percent annually. What is ICU's pretax cost of debt? If the tax rate is 38 percent, what is the aftertax cost of debt?

The pretax cost of debt is the YTM of the companys bonds, so:

R = 3.438%

YTM = 2 3.438%

YTM = 6.88%

***********************************************************************

N = 2 x 7 = 14

PV = .93 x 1,000 = -930

PMT = (.056 x $1,000) / 2 = 28

FV = 1000

RD(1 TC) = .042636 or 4.26%

The Cost of Preferred Stock The cost of preferred stock financing can also be observed in the financial

markets. A firm which expects to issue preferred stock would compute the yield for either its own currently

outstanding preferred stock issue or for preferred stock issued by other firms with ratings similar to the

proposed offering.

Prepared by Jim Keys 4

Preferred stock is generally considered to be a perpetuity, so you rearrange the perpetuity equation to get

the cost of preferred, RP:

RP = D / P 0

Sixth Fourth Bank has an issue of preferred stock with a $6 stated dividend that just sold for $94 per share. What is the

bank's cost of preferred stock?

E = market value of the firms equity = # outstanding shares times price per share

D = market value of the firms debt = # bonds times price per bond

V = combined market value of the firms equity and debt = E + D (Assuming that there is no preferred stock

and current liabilities are negligible. If this is not the case, then you need to include these

components as well. This is really just the market value version of the balance sheet identity. The

market value of the firms assets = market value of liabilities + market value of equity.)

Using the symbol V (for value) to stand for the combined market value of the debt and equity:

V=E+D

If we divide both sides by V, we can calculate the percentages of the total capital represented by the debt and

equity:

These percentages can be interpreted just like portfolio weights, and they are often called the capital structure

weights. For example, if the total market value of a company's stock were calculated as $200 million and the

total market value of the company's debt were calculated as $50 million, then the combined value would be

$250 million. Of this total, E/V = $200/250 = 80%, so 80 percent of the firm's financing would be equity and

the remaining 20 percent would be debt. We emphasize here that the correct way to proceed is to use the market

values of the debt and equity. Under certain circumstances, such as when considering a privately owned

company, it may not be possible to get reliable estimates of these quantities, and book values must be used.

Taxes and the Weighted Average Cost of Capital We are always concerned with aftertax cash flows. If we

are determining the discount rate appropriate to those cash flows, then the discount rate also needs to be

expressed on an aftertax basis. Interest is a tax-deductible expense, while dividends paid to stockholders are

not tax-deductible. Therefore, the cost of capital calculation must be adjusted to reflect this differential tax

treatment.

If the firm also uses preferred stock in its capital structure, then the WACC is as follows:

Prepared by Jim Keys 5

WACC = (E/V)(RE) + (P/V)(RP) + (D/V)(RD)(1 TC)

Note: The cost of preferred stock = RP and the percentage of preferred stock in the capital structure = P/V

The WACC is the overall return the firm must earn on its existing assets to maintain the value of the stock. It is a

market rate that is based on the markets perception of the risk of the firms assets.

Mullineaux Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25

percent debt. Its cost of equity is 14 percent, the cost of preferred stock is 6 percent, and the cost of debt is 7.5 percent.

The relevant tax rate is 35 percent.

b. The company president has approached you about Mullineaux's capital structure. He wants to know why the

company doesn't use more preferred stock financing, since it costs less than debt. What would you tell the president?

Since interest is tax deductible and dividends are not, we must look at the aftertax cost of debt, which is:

Solving the Warehouse Problem and Similar Capital Budgeting Problems

The warehouse problem employs the WACC as the discount rate in an NPV calculation. This is only appropriate

if the warehouse has approximately the same risk characteristics as the overall firm. A second assumption that is

often discussed in financial literature is that the project should be financed with the same proportion of debt

versus equity as used in the WACC. However, as discussed earlier, the appropriate

discount rate for a project depends on the risk of the project, not on how it is paid for. The WACC is the best

estimate we have of the markets perception about the risk of the firm and the required return, given that risk.

Consequently, the key assumption is that the project is the same risk as the firms current assets.

The SML and the WACC: The WACC is the appropriate discount rate only if the proposed investment is of

similar risk as the firms existing assets; riskier (less risky) projects should be evaluated against higher

(lower) capital costs.

The security market line, SML, and the weighted average cost of capital, WACC

When a firm has different operating divisions with different risks, its WACC is an average of the

divisional required returns. In such cases, the cost of capital for projects of average risk in each division

needs to be established.

If you do use the firms WACC across divisions, then riskier divisions will receive the bulk of the

funding while less-risky divisions will have to forego what would be good projects if the appropriate

discount rate were used. This will lead to an increase in risk for the overall firm.

The Pure Play Approach - A pure play is a company that has a single line of business. The idea is to find the

required return on a near substitute investment.

The Subjective Approach - Assigns investments to risk categories that have higher or lower risk premiums

than the firm as a whole.

Finding the WACC. Given the following information for Janicek Power Co., find the WACC. Assume the company's

tax rate is 35 percent.

Debt: 6,500 8.5 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity,

selling for 104 percent of par; the bonds make semiannual payments.

Common

150,000 shares outstanding, selling for $78 per share; beta is 1.15.

stock:

Preferred 10,000 shares of 6.25 percent preferred stock outstanding, currently selling for $80 per

stock: share.

Market: 8 percent market risk premium and 5.25 percent risk-free rate.

2) Find the cost of equity, RE, using the CAPM:

3) Compute the YTM of the outstanding bonds; this is RD:

4) Calculate the cost of preferred stock, RP:

5) Compute the WACC:

- Capital Structure,Cost of Capital & ValuationUploaded byRia Singh
- 07 b Cost of CapitalUploaded byShekhar Singh
- Chapter 15 Capital Structure and LeverageUploaded byBritt John Ballentes
- Cost of Capital(Final)Uploaded byMohammad Salim Hossain
- Lecture 3Uploaded bydr.pavnesh2418
- Corporate Finance Quiz HelperUploaded byparatroop6662000
- New Microsoft Word DocumentUploaded byawaljan
- Final_version_TPgroup5_philips_LightingUploaded byPeter Bakker
- Fm unit IIIUploaded bySrinivasan Kuppusamy
- Capital Structure 1Uploaded byhima001
- marriottcase-160802220034.docxUploaded byDurgesh Chauhan
- MOP-Capital theory Assignment-020310Uploaded bycharnu1988
- Chapter 21 - Capital Structure DecisionsUploaded bySabith Gassali
- Finance Chapter 9Uploaded bymamarcus-1
- Capital StructureUploaded bysimmi33
- FinGame 5.0 Participants Ch03Uploaded byMartin Vazquez
- Advanced Tech QuestionsUploaded bynmdau13
- Cost of CapitalUploaded byVivek Mishra
- Cost of CapitalUploaded byManthan Kulkarni
- GST – Practice Pointer IssuesUploaded byShankar Reddy
- Levering and Unlevering Betas IIUploaded bymrjohnse
- SSRN Id1980014 IgnatiusUploaded bySteven Heriyanto
- Cost of CapitalUploaded byJustin Renovated
- 48701-181560-1-PBUploaded byRidhosyah Yazid Putra
- Advanced Finance Write UpUploaded byMark Kettlewell
- Cost of Service ManualUploaded byvkartikey
- Chapter 5 - Cost of Capital SML 401 Btech (1)Uploaded byfike
- Financial Management Tutorial QuestionsUploaded byStephen Olieka
- F3 Adjusted Present ValueUploaded bythrind
- Pioneer DistilleriesUploaded byKaustubh Agrawal

- Chapter 6-Single Phase Systems 1Uploaded byAbdussalam Al-hakimi Mohd Tahir
- Shake Flask AnalysisUploaded byAbdussalam Al-hakimi Mohd Tahir
- Working Principle (1)Uploaded byAbdussalam Al-hakimi Mohd Tahir
- COD Test Report Latest 2012Uploaded byemmafatimah
- gcpUploaded byAbdussalam Al-hakimi Mohd Tahir
- Fermentation Assgn 2Uploaded byAbdussalam Al-hakimi Mohd Tahir
- Carbohydrate Polymers Volume 94 Issue 1 2013 [Doi 10.1016_j.carbpol.2013.01.010] Liu, Tingguo; Qian, Liwu; Li, Bin; Li, Jing; Zhu, Kunkun; Deng, -- Homogeneous Synthesis of Chitin-based Acrylate SupUploaded byAbdussalam Al-hakimi Mohd Tahir
- Suggestion and Recommendation Separation Cooling TowerUploaded byAbdussalam Al-hakimi Mohd Tahir
- Entrepreneurship 2018Uploaded byAbdussalam Al-hakimi Mohd Tahir
- Chapter 01 DesignUploaded byAbdussalam Al-hakimi Mohd Tahir
- Chap 2 DesignUploaded byAbdussalam Al-hakimi Mohd Tahir
- Exp.3 Result AnalysisUploaded byAbdussalam Al-hakimi Mohd Tahir
- EET FOCUploaded byAbdussalam Al-hakimi Mohd Tahir
- Mass Balance Practice Problems F04Uploaded byKZS1996
- Overview EE AssignmentUploaded byAbdussalam Al-hakimi Mohd Tahir
- Ke Simp UlanUploaded byAbdussalam Al-hakimi Mohd Tahir
- pengesahan pendapatanUploaded byAbdussalam Al-hakimi Mohd Tahir
- Contoh Fyp Tam Hong KeiUploaded byAbdussalam Al-hakimi Mohd Tahir
- Past Year Engineering EconomyUploaded byAbdussalam Al-hakimi Mohd Tahir
- Disser t Title PageUploaded byCharity Omz
- cost of capital.docUploaded byAbdussalam Al-hakimi Mohd Tahir
- cost of capital.docUploaded byAbdussalam Al-hakimi Mohd Tahir
- KFC KEUSAHAWANAN.docxUploaded byabdussalam
- Teks Mc Majlis Penutup Program Anak Angkat 2.0Uploaded byAbdussalam Al-hakimi Mohd Tahir
- Light Microscopy HandoutUploaded byDevaprakasam Deivasagayam
- Light Microscopy HandoutUploaded byDevaprakasam Deivasagayam
- soy-sauceUploaded byAbdussalam Al-hakimi Mohd Tahir
- Understanding Pressure and Pressure MeasurementUploaded byAbdul-Wahab Anwar

- Assignment on Pecking Order TheoryUploaded byYAKUBU ISSAHAKU SAID
- Chapter 4Uploaded byTinku Kumar
- 16 x11 FinMan DUploaded byErwin Cajucom
- SMU Assignment paper- MB045Uploaded byPankaj Raaj
- MBA Assignments Sem 2Uploaded byNikhil Keshav
- Financial ManagementUploaded byNelsonMoseM
- Corporate Finance - Course OutlineUploaded bymissay1991
- PIJMR-Vol4(2)-Vol5(1)Uploaded byPhoneix12
- Capital StructureUploaded byVinoth S
- GGP Reorganization 072010Uploaded byChris Alleva
- CA_IPCC_Costing_Nov_14_Guideline_Answers.pdfUploaded bymohanraokp2279
- Capital Cash Flow ValuatioonUploaded byFaas1337
- Capital Structure and Financial OfferingUploaded byVictoria Mabini
- 20130705104826-mba-retail-mgtUploaded byanshul
- Impact of Profitability-2Uploaded byjashish4
- Chapter 16 Planning the Firm's Financing MixUploaded byJoy Funcion Toledo
- Chapter 01Uploaded byohusman
- F3 Revision SummariesUploaded bysolo7e
- Comprehensive Finance Review - 2010Uploaded byLBL_Lowkee
- ValueAdd - Sell-Side Equity Research (June 2017) (1)Uploaded byValueadd Research
- Lecture-Notes-Final.pdfUploaded bycomaixanh
- Damodaran's Optimal Capital StructureUploaded byRajaram Iyengar
- QBIVSemBBACoreFinancialmgmntUploaded bySuvrasoumya Mohanty
- Viet Anh Dang-Empirical AnalysisUploaded bySastrawan Sugiandi
- Financial ManagementUploaded byyalang
- TN 34 the Wm Wrigley Jr Company Capital Structure Valuation and Cost of CapitalUploaded byStanisla Lee
- Capital Structure TheoriesUploaded byvijayjeo
- Advance Stochastic Calculus (Abstracts).pdfUploaded byFranciscoMuñozElguezabal
- Project Report on Capital Structure of RanbaxyUploaded byAkshay Jadav
- 2015 Part 2 Question Book CMA ExamUploaded bySwathi Ashok