Professional Documents
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LU 6. Cost - of - Capital
LU 6. Cost - of - Capital
Sources of Capital
Component Costs
WACC
Adjusting for Flotation Costs
Adjusting for Risk
11-1
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What sources of capital do firms use?
11-2
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Calculating the Weighted Average Cost of Capital
11-3
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Should our analysis focus on before-tax or after-
tax capital costs?
11-4
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Should our analysis focus on historical (embedded)
costs or new (marginal) costs?
11-5
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How are the weights determined?
11-6
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Overview of Coleman Technologies Inc.
11-9
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A 15-year, 12% semiannual coupon bond sells for
$1,153.72. What is the cost of debt (rd)?
11-10
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Component Cost of Debt
11-11
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Component Cost of Preferred Stock
11-12
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What is the cost of preferred stock?
rp = Dp/Pp
= $10/$111.10
= 9%
11-13
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Is preferred stock more or less risky to investors than
debt?
11-14
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Why is the yield on preferred stock lower than debt?
11-15
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Component Cost of Equity
11-16
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Why is there a cost for retained earnings?
11-17
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Three Ways to Determine the Cost of Common
Equity, rs
• DCF: rs = (D1/P0) + g
• Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
11-18
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Find the Cost of Common Equity Using the CAPM
Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
11-19
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Find the Cost of Common Equity Using the DCF
Approach
D1 = D0(1 + g)
= $4.19(1 + 0.05)
= $4.3995
rs = (D1/P0) + g
= ($4.3995/$50) + 0.05
= 13.8%
11-20
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Can DCF methodology be applied if growth is not
constant?
11-21
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Find rs Using the Bond-Yield-Plus-Risk-Premium
Approach
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
11-22
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What is a reasonable final estimate of rs?
Method Estimate
CAPM
14.2%
DCF 13.8
rd + RP 14.0
11-23
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Why is the cost of retained earnings cheaper than the
cost of issuing new common stock?
11-24
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If new common stock issue incurs a flotation cost of
15% of the proceeds, what is re?
D0 (1 g)
re g
P0 (1 F)
$4.19(1.05)
5.0%
$50(1 0.15)
$4.3995
5.0%
$42.50
15.4%
11-25
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Flotation Costs
11-26
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Ignoring flotation costs, what is the firm’s WACC?
11-27
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What factors influence a company’s composite
WACC?
• Market conditions.
• The firm’s capital structure and dividend policy.
• The firm’s investment policy. Firms with riskier
projects generally have a higher WACC.
11-28
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Should the company use the composite WACC as the
hurdle rate for each of its projects?
11-29
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Divisional Cost of Capital
11-30
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