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# Prof.

Rushen Chahal

CHAPTER 12

Cost of Capital
CHAPTER ORIENTATION
In Chapters 7 and 8 we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects.

CHAPTER OUTLINE
I. The concept of the cost of capital A. Defining the cost of capital: 1. 2. B. The rate that must be earned in order to satisfy the required rate of return The rate of return on investments at which the price of a firm's common stock will remain unchanged.

Investors required rate of return is not the same as the firms cost of capital due to 1. 2. Taxes: Interest payments on debt are tax deductible to the firm. Flotation costs: Firms incur expenses when issuing securities that reduce the proceeds to the firm. Each type of capital used by the firm (debt, preferred stock, and common stock) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using the cost of a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems.

C.

Financial Policy 1.

2.

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## Prof. Rushen Chahal

II. Computing the weighted cost of capital. A firm's weighted cost of capital is a function of (l) the individual costs of capital, (2) the capital structure mix, and (3) the level of financing necessary to make the investment. A. Determining individual costs of capital. 1. The before-tax cost of debt is found by trial-and-error by solving for kd in NPd where = NPd \$It \$M kd n
t =1

\$I t (1 + k d ) = = = = =
t

\$M (1 + k d ) n

the market price of the debt, less flotation costs, the dollar interest paid to the investor each period, the maturity value of the debt before-tax cost of the debt (before-tax required rate of return on debt) the number of periods to maturity.

The after-tax cost of debt equals: kd (1 - T) where T = corporate tax rate 2. Cost of preferred stock (required rate of return on preferred stock), kps, equals the dividend yield based upon the net price (market price less flotation costs), or D dividend kps = = net price NPps 3. Cost of Common Stock. There are two measurement techniques to obtain the required rate of return on common stock. a. b. 4. dividend-growth model capital asset pricing model Cost of internally generated common equity, kcs kcs = kcs = dividend in year1 annual growth + in dividends market price D1 + g Pcs

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## Prof. Rushen Chahal

b. Cost of new common stock, kncs D1 kncs = + g NPcs where NPcs = the market price of the common stock less flotation costs incurred in issuing new shares. 5. Capital asset pricing model kc where kc krf km 6. = = = = = krf + (km - krf) the cost of common stock the risk-free rate beta, measure of the stock's systematic risk the expected rate of return on the market

It is important to notice that the major difference between the equations presented here and the equations from Chapters 7 and 8 is that the firm must recognize the flotation costs incurred in issuing the security.

B.

Selection of weights. The individual costs of capital will be different for each source of capital in the firm's capital structure. To use the cost of capital in investment analyses, we must compute a weighted, or overall, cost of capital. 1. It will be assumed that the company's current financial mix resulting from the financing of previous investments is relatively stable and that these weights will closely approximate future financing patterns. In computing weights, we could use either the current market values of the firm's securities or the book values as shown in the balance sheet. Since we will be issuing new securities at their current market value, and not at book (historical) values, we should use the market value of the securities in calculating our weights.

2.

III.

PepsiCo approach to weighted average cost of capital A. PepsiCo calculates the divisional cost of capital for its snack, beverage and restaurant organizations by first finding peer-group firms for each division and using their average betas, after adjusting for differences in financial leverage, to compute the division's cost of equity. They also use accounting betas in estimating the cost of equity. They then compute the cost of debt for each division. Finally, they calculate a weighted cost of capital for each division.

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## Prof. Rushen Chahal

B. PepsiCo's WACC basic computation E kwacc = kcs + kd[1-T] D+E where: kwacc = kcs kd T = = = the weighted average cost of capital the cost of equity capital the before-tax cost of debt capital the marginal tax rate percentage of financing from equity percentage of financing from debt D D+E

E/(D+E)= D/(D+E)= C.

Calculating the Cost of Equity Based on capital asset pricing model: kcs where: kcs krf km = = = = the cost of common stock the risk-free rate beta, measure of the stock's systematic risk the expected rate of return on the market = krf + (km - krf)

Betas for each division are estimated by calculating an average unlevered beta from a group of divisional peers. The average beta for each division's peer group is unlevered and then relevered using that division's target debt-to-equity ratio. D. Calculating the Cost of Debt The after-tax cost of debt is equal to: kd (1 - T) where: kd T = = before-tax cost of debt marginal tax rate

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## Prof. Rushen Chahal

IV. Required rate of return for individual projects A. Using the weighted cost of capital. Investments with an internal rate of return exceeding the weighted cost of capital should be accepted. Doing so, we must assume that the project has similar business risk as existing assets. Otherwise, the weighted cost of capital does not apply. The weighted cost of capital, kwacc does not allow for varying levels of project risk. We need to specify the appropriate required rates of return for investments having different amounts of risk. Risk also results from the decisions made within the company. This risk is generally divided into two classes: 1. 2. Business risk is the variability in returns on assets and is affected by the companys investment decisions. Financial risk is the increased variability in returns to the common stockholder as a result of using debt and preferred stock.

B.

C.

12-1. The cost of capital is the rate that must be earned on investments in order to satisfy the required rate of return of the firm's investors. This rate is a function of the investors' required rate of return, the corporation's tax rate, and the flotation costs incurred in issuing new securities. Therefore, the cost of capital determines the rate of return that must be achieved on the company's investments, so as to earn the target return of the firm's investors. Stated differently, the cost of capital is the rate of return that will leave the price of the common stock unchanged. 12-2. Two objectives may be given for determining a company's weighted average cost of capital: (1) The weighted average cost of capital is used as the minimum acceptable rate of return for capital investments. The value of the firm should be maximized by accepting all projects where the net present value is positive when discounted at the firm's weighted average cost of capital. The weighted average cost of capital is also used in evaluating a firms historical performance. That is, to create shareholder value a firm must not only earn a profit in the traditional accounting sense, but it must earn a return on its invested capital that is acceptable to the investors who provide the firms financing. This acceptable return is the firms weighted average cost of capital.

(2)

12-3. All types of capital, including debt, preferred stock, and common stock, should be incorporated into the cost of capital computation, with the relative importance of a particular source being based upon the percentage of financing to be provided.

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## Prof. Rushen Chahal

12-4. The effect of taxes on the firm's cost of capital is observed in computing the cost of debt. Since interest is a tax deductible expense, the use of debt indirectly decreases the firm's taxes. Therefore, since we have computed the internal rate of return on an after-tax basis, we also compute the cost of debt on an after-tax basis. In completing a security offering, investment bankers and other involved individuals receive a commission for their services. As a result, the amount of capital net of these flotation costs is less than the funds invested by the individual purchasing the security. Consequently, the firm must earn more than the investors' required rate of return to compensate for this leakage of capital. 12-5. a. Equity capital can be raised by either retaining profits within the firm or by issuing new common stock. Either route represents funds invested by the common stockholder. The first avenue simply indicates that the common stockholder permits management to retain capital that could be remitted to these investors. Even though a new stock issue does not result from retaining internal common equity, these funds should not be reinvested unless management can reasonably expect to satisfy the investors' required rate of return. In essence, even though no explicit out-of-pocket cost results from retaining the capital, the cost in measuring a firm's cost of capital is actually the opportunity cost associated with these funds for the investor. The two popular methods for computing the cost of equity capital include (1) the dividend-growth model, and (2) the capital asset pricing model. The first approach finds the rate of return that equates the present value of future dividends, assuming a constant growth rate, with the current market price of the security. The CAPM finds the appropriate required rate of return, given the firm's systematic risk.

b.

c.

12-6

In general, the relative costs of various sources of capital reflect the riskness of the source to the investor. For example, for a given firm, we would expect debt securities to be less risky than preferred stock which is less risky than common stock. Consequently, debt would demand a lower required return than the firms preferred stock, which is lower than the required rate of return for common stock.

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## Prof. Rushen Chahal

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
The following notations are used in this group of problems: kps kcs kncs g kd T Dt P NP 12-1A. a. Net price after flotation costs = = \$1068.75 kd = = \$1,125 (1 - .05) \$1068.75 = = = = = = = = = the cost of preferred stock. the cost of internally generated common funds the cost of new common stock. the growth rate. the before-tax cost of debt. the marginal tax rate. dollar dividend per share, where Do is the most recently paid dividend and D1 is the forthcoming dividend. the value (present value) of a security. the value of a security less any flotation costs incurred in issuing the security

t =1

10

b.

kncs

= =

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## Prof. Rushen Chahal

c. kcs = D1 + g Pcs \$3.50 + .07 \$43 .1514 = 15.14% D .09 x\$150 = NPps \$175(1 .12) \$13.50 \$154 .0877 = 8.77%

= = d. kps =

= = e.

## After tax cost of debt = kd (1 - T) = 12% (1 - .34) = 7.92%

12-2A. a. After tax cost of debt = = = b. kncs kncs c. \$1,150(.90) \$1,035 Rate = kd(1 - T) 8%(1 - 0.34) 5.28% D1 + g NPcs \$1.05(1 + 0.05) + 0.05 \$25(1 0.09) \$1,035 = = 9.85%

= = =

t =1

20

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## Prof. Rushen Chahal

For: 11% kd% 12% \$ 44.56 kd = \$44.56 0.11 + 0.01 \$79.56 = = D NPps \$7 \$85 D1 + g Pcs \$3 + 0.04 \$38 D1 + g NPcs \$1.45(1 + 0.06) + 0.06 \$27(1 0.06) = .1206 = 12.06% = 11.90% = 8.24% kd (1 - T) 11.56% (1 - 0.34) = 7.63% = \$1,079.56 1,035.00 1,000.00 \$ 79.56 .1156 = 11.56% \$1,079.56

After tax cost of debt After tax cost of debt d. kps kps e. kcs kcs =

12-3A.

kncs

kncs

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## Prof. Rushen Chahal

12-4A. \$958 (1 - 0.11) \$852.62 Rate For: 8% kd% 9% = = \$852.62 = the net price (value less flotation costs).
15

t =1

## \$70 (1 + k d ) Value \$914.20 852.62 ______ \$61.58

t

\$1,000 (1 + k d )15 Value \$914.13 839.27 \$74.86 .0882 = 7.23% = 7.69% = 8.82%

kd

t t

12-5A.

kps

D NPps
n

## \$2.50 \$32.50 + \$M (1 + k d ) n \$1,000 (1 + k d )15

12-6A.

NPd

t =1 15

\$945

t =1

Since the net price on the bonds, \$945, is less than the \$1,000 par value, the beforetax cost of the debt must be greater than the 12 percent coupon interest rate (\$120 \$1,000). Rate 12% kd% 13% Value \$1,000.00 945.00 _______ \$ 55.00 kd = 935.44 \$ 64.56 Value \$1,000.00

\$55.00 .12 + .01 = .1285 = 12.85% \$64.56 = kd(1 - T) = 12.85%(1 - .34) = 8.48% 59

## Prof. Rushen Chahal

12-7A. Cost of preferred stock (kps) kps = = = 12-8A. kcs = D Dividend = NPps Net Price 14% x \$100 \$14 = \$98 \$98 14.29% D1 + g Pcs \$0.70(1 + 0.15) + 0.15 \$21.50 .1874 = 18.74%

= =

12-9A.If the firm pays out 50 percent of its earnings in dividends, its recent earnings must have been \$8 (\$4 dividend divided by .5). Thus, earnings increased from \$5 to \$8 in five years. Using Appendix C and looking for a table value of .625 (\$5/\$8), the annual growth rate is approximately ten percent. a. Cost of internal common stock (kcs): kcs = D1 P + g cs \$4(1 + .10) \$4.40 + .10 = + .10 \$58 \$58 .1759 = 17.59%

= = b.

Cost of external common (new common) stock, kncs kncs = D1 NP + g cs \$4.40 + .10 \$58(1 0.08) \$4.40 + .10 \$53.36

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## Prof. Rushen Chahal

= 12-10A. a. Price (Pd) = = = b. NPd = =
10 t =1

## .1825 = 18.25% \$140 (1 + 0.09)

t

\$1,000 (1 + 0.09)10

\$140(6.418) + \$1000(.422) \$1,320.52 \$1,320.52(1 - 0.105) \$1,181.87 \$500,000 = 423.06 424 Bonds \$1,181.87

c.

Number of Bonds

d.

10

t =1

\$140 (1 + k d )
t

kd

## \$64.43 0.10 + (0.01) = .1092 = 10.92% \$69.84

After tax cost of debt = 10.92%(1 - 0.34) = 7.21% 12-11A. a. 1. Price (Pd) = =
10 t =1

\$100 (1 + 0.09) t

\$1,000 (1 + 0.09)10

61

= \$1,063.80

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## Prof. Rushen Chahal

2. NPd = = 3. Number of Bonds \$1,063.80 (1 - 0.105) \$952.10 = = 4. Cost of debt: \$952.10 Rate For: 10% kd% 11% =
10

t =1

\$100 (1 + k d )
t

## \$47.90 0.10 + (0.01) = .1081 = 10.81% \$59.10 10.81%(1 - 0.34) = 7.13%

There is a very slight decrease in the cost of debt because the flotation costs associated with the higher coupon bond are higher (\$138.65 in flotation costs for the 14 percent coupon bond versus \$111.70 for the 10 percent coupon bond).

12-12A. Source Common Stock Preferred Stock Debt Capital Structure 40% 10% 50% After-tax cost of capital 18% 10% 8% x (1-.35) kwacc = Weighted cost 7.2% 1.0% 2.6% 10.8%

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## Prof. Rushen Chahal

12-13A. Net price after flotation costs = = Cost of debt: \$960.00 Rate For: 6% kd% 7% = = \$975 - \$15 \$960.00

t =1

15

## \$40.00 0.06 + (0.01) = .064 = 6.4% \$91.52 = 6.4%(1 - 0.30) = 4.48%

D1 NP + g cs \$2.25 + .05 \$30(1 0.05) .129 = 12.9% Capital Structure 60% 40% After-tax cost of capital 4.48% 12.9% kwacc = Weighted cost 2.69% 5.16% 7.85%

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## Prof. Rushen Chahal

12-14A. Net price after flotation costs Cost of debt: \$1,008.00 Rate For: 6% kd% 7% = = = = = \$1,050 (1-.04) \$1,008.00

t =1

10

## Value \$1,096.84 1,008.00 ________ \$ 88.84

kd After tax cost of debt Cost of preferred stock (kps) kps = = = Cost of common stock, kncs kncs =

\$88.84 0.06 + (0.01) = .069 = 6.9% \$96.84 6.9 %(1 - 0.30) = 4.8%

## D Dividend = NPps Net Price \$2.00 \$2 = \$25 \$3 \$22

.091 = 9.1%

D1 NP + g cs \$3(1 + .10) + .10 \$55 \$5 .166 = 16.6% Weight .33 .17 .50 1.00 65 After-tax cost of capital 4.8% 9.1% 16.6% kwacc = Weighted Cost 1.6% 1.5% 8.3% 11.4%

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## Prof. Rushen Chahal

SOLUTION TO INTEGRATIVE PROBLEM
Nealon, Inc. - Weighted Cost of Capital Cost of Debt: \$1,035 (1 - .15) \$879.75 Rate For: 9% kd% 10% = = \$879.75
16

= NPd
t

t =1

\$80 (1 + k d )

kd

## Cost of Preferred Stock: kps = D NPps = \$1.50 (\$19 \$2.01) = 8.83%

Cost of Internal Common Equity: kcs = D1 + g Pcs \$2.50(1 + 0.06) + 0.06 \$35 .1357 = 13.57%

= =

Weighted Cost of Capital (kwacc) is calculated as follows: Bonds Preferred Stock Common Stock Weights .38 .15 .47 1.00 67 Costs 6.28% 8.83% 13.57% Weighted Costs 2.39% 1.32% 6.38% kwacc = 10.09%

## Prof. Rushen Chahal

Solutions for Problem Set B
The following notations are used in this group of problems: kps kcs kncs g kd T Dt P NP 12-1B. a. Net price after flotation costs = = \$1,057.50 Rate For: 11% kd% 12% =
10

= = = = = = = = =

the cost of preferred stock. the cost of internally generated common funds the cost of new common stock. the growth rate. the before-tax cost of debt. the marginal tax rate. dollar dividend per share, where Do is the most recently paid dividend and D1 is the forthcoming dividend. the value (present value) of a security. the value of a security less any flotation costs incurred in issuing the security

## \$1,125 (1 - .06) \$1,057.50

t

t =1

\$120 (1 + k d ) Value

## \$1,058.68 1,057.50 \$ 1.18

kd

\$1.18 .11 + .01 = .1102 = 11.02% \$58.68 = = kd(1 - T) 11.02%(1 - .34) = 7.27%

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## Prof. Rushen Chahal

b. kncs = D1 + g NPcs \$1.75(1 + .08) + .08 \$28.00(1 .05) .1511 = 15.11% D1 + g Pcs \$3.25 + .07 \$43.50 .1447 = 14.47% D .10 (\$125) = NPps \$150(1 .12) \$12.5 \$132 .0947 = 9.47% = = = 12-2B. a. After tax cost of debt After tax cost of debt After tax cost of debt = = = kd(1 - T) 9%(1 - 0.34) 5.94% kd (1 - T) 13% (1 - .34) 8.58%

= = c. kcs =

= = d. kps =

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## Prof. Rushen Chahal

b. kncs kncs c. = D1 + g NPcs \$1.25(1 + 0.06) + 0.06 = 10.85% \$30(1 0.09) = = Rate 12% kd% 13% \$1,012.50 = net price after flotation costs

\$1,125(.90) \$1,012.50

t =1

20

\$1,000 \$130 20 + (1 + k d ) (1 + k d ) t Value \$1,074.97 1,012.50 \$ 62.47 Value \$1,074.97 1,000.00 \$ 74.97

For:

= = = D NPps

.1283 = 12.83%

8.47%

= =

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## Prof. Rushen Chahal

12-3B. kncs = D1 NPcs + g

kncs 12-4B.

15 t =1

## \$950 (1 - 0.11) \$845.50 = Rate 10% kd% 11% =

\$845.50 = the net price (value less flotation costs). \$80 (1 + k d ) Value \$847.48 845.50 \$1.98
t

For:

kd

## D \$2.75 = = 8.46% NPps \$32.50

n

12-6B.

NPd \$950

= =

\$I t (1 + k d ) \$130 (1 + k d ) t
t

t =1 15

+ +

\$M (1 + k d ) n \$1,000 (1 + k d )15

t =1

Since the net price on the bonds, \$950, is less than the \$1,000 par value, the beforetax cost of the debt must be greater than the 13 percent coupon interest rate (\$130 \$1,000). Rate 13% kd% 14% Value \$1,000.00 950.00 \$ 50.00 kd = Value \$1,000.00 938.46 \$ 61.54

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## Prof. Rushen Chahal

After tax cost of debt 12-7B. = kd(1 - T) = 13.81%(1 - .34) = 9.11%

Cost of preferred stock (kps) = = = D Dividend = NPps Net Price 13% x\$100 \$13 = \$97 \$97 13.40% D1 + g Pcs \$0.80(1 + 0.16) + 0.16 \$22.50

12-8B.

kcs

= =

= .2012 = 20.12% 12-9B. If the firm pays out 50 percent of its earnings in dividends, its recent earnings must have been \$9 (\$4.50 dividend divided by .5). Thus, earnings increased from \$5 to \$9 in five years. Using Appendix C and looking for a table value of .556 (\$5/\$9), the annual growth rate is approximately twelve percent. a. Cost of internal common stock (kcs): kcs = = = = b. D1 P + g cs \$4.50(1 + .12) + .12 \$60 \$5.04 + .12 \$60 .204 = 20.4%

Cost of external common (new common) stock, kncs kncs = D1 NP + g cs \$5.04 + .12 \$60(1 0.09)

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## Prof. Rushen Chahal

= = 12-10B. a. Price (Pd) = = = b. NPd = = c. Number of Bonds
10 t =1

## \$5.04 + .12 \$54.60 .2123 = 21.23% \$150 (1 + 0.10)

t

\$1,000 (1 + 0.10)10

\$150(6.145) + \$1000(.386) \$1,307.75 \$1,307.75(1 - 0.115) \$1,157.36 = = \$600,000 \$1,157.36 518.4 519 bonds

d.

Cost of debt: \$1,157.36 Rate For 12% kd% 13% \$ 12.14 kd = = 10 \$150 \$1,000 t + t = 1 (1 + k d ) (1 + k d )10 Value \$1,169.50 1,157.36 1,108.90 \$ 60.60 Value \$1,169.50

## After tax cost of debt 12-11B. a. 1.

Price (Pd)

= =

t=

10

\$100 (1 + 0.10) t

\$1,000 (1 + 0.10)10

## Prof. Rushen Chahal

= 2. NPd = = 3. Number of Bonds \$1,000.00 \$1,000.00 (1 - 0.115) \$885.00 = = 4. Cost of debt: \$885.00 =
10 t =1

## \$600,000 \$885.00 678 Bonds

\$100 (1 + k d ) t

For:

kd

## After tax cost of debt

b,There is a very slight decrease in the cost of debt because the flotation costs associated with the higher coupon bond are higher (flotation costs are \$150.39 for the 15 percent coupon bond versus \$115 for the 10 percent coupon bond) 12-12B. Bias Corporation - Weighted Cost of Capital Capital Structure \$1,100 250 3,700 \$5,050 Weights 0.2178 0.0495 0.7327 1.0000 Individual Costs 6.0% 13.5% 19.0% Weighted Costs 1.31% 0.67% 13.92% 15.90%

## Prof. Rushen Chahal

Preferred Stock Debt 15% 35% 100% 12% 10% (1-.34) kwacc = 1.8% 2.3% 14.1%

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## Prof. Rushen Chahal

12-14B. Net price after flotation costs Cost of debt: \$1,080.00 = = =
40

t =1

## Value \$1,231.60 1,080.00 ________ \$ 151.60

semi-annual kd annual kd After tax cost of debt Cost of common stock, kncs kncs =

= = =

\$151.6 0.03 + (0.01) = .0365 = 3.65% \$231.60 3.65% x 2 = 7.3% 7.3%(1 - 0.34) = 4.8%

D1 NP + g cs \$2.00 + .08 \$80(1 0.10) .108 = 10.8% Capital Structure 60% 40% After-tax cost of capital 10.8% 4.8% kwacc = Weighted cost 6.48% 1.92% 8.4%

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## Prof. Rushen Chahal

12-15B. Net price after flotation costs Cost of debt: \$893.00 Rate 9% kd% 10% = = =
20

t =1

For:

kd

## \$15.32 0.09 + (0.01) = .092 = 9.2% \$78.20

After tax cost of debt = 10.4 % x (1 - 0.34) = 6.07% Cost of preferred stock (kps) kps = = = Cost of common stock, kncs kncs = D1 NP + g cs \$2(1 + .08) + .08 \$50(1 .10) .128 = 12.8% Weight .50 .10 .40 1.00 77 After-tax cost of capital Weighted Cost 6.07% 3.04% 8.3% 12.8% kwacc = .83% 5.12% 8.99% D Dividend = NPps Net Price \$2.50 \$2.50 = \$35 \$5 \$30 .083 = 8.3%

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