Unit 7. Types of Capital Debt Preferred Stock Common Equity New Common Stock Retained Earnings.
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Transcript of Unit 7. Types of Capital Debt Preferred Stock Common Equity New Common Stock Retained Earnings.
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Unit 7
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Types of Capital
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Weighted Average Cost of Capital (WACC)
A weighted average of the component costs of debt, preferred stock, and common equity.
WACC= (% of debt)(After-tax cost of debt) + (% of preferred stock)(Cost of preferred stock) + (% of common equity)(Cost of common equity)
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CAPM & CGM
This should be a review of the previous unit:
CAPM: rs=rRF + bi (RPM)
CGM: Po= D1/rs-g
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Cost of Preferred Stock
Cost of preferred stock= rP = DP/PP
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Example
Suppose you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm’s WACC?
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AnswerWeight Cost
Debt 40% 4%
Preferred 10% 7.50%
Common 50% 11.5%
WACC= wdrd + wprp + wsrs
WACC= .40(4%) + .10(7.50%) + .50(11.50%) = ?
=8.10%
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Example
Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation?
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Answer
First, you need to calculate the YTM on this bond. Input data into calculator:
N: 100; PV= -900.90; PMT: 20; FV= 1000; I/Yr =?Make sure that your cell is formatted to 2
decimal places.(Hint: This is the quarterly rate. You must
change to annual rate by multiplying by 4)……cont.
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Answer
The YTM = 9% The YTM is the before tax cost of debt. Next,
you need to calculate the after-tax cost of debt:
YTM: 9%Tax rate: 40%After tax cost of debt: 9% * (1-.40)= 5.40%
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Example Tapley Inc. recently hired you as a consultant to estimate
the company’s WACC. You have obtained the following information. (1) Tapley's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market price of $936.49. (2) The company’s tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and the stock’s beta is 1.5. (4) The target capital structure consists of 30% debt and 70% equity. Tapley uses the CAPM to estimate the cost of equity, and it does not expect to have to issue any new common stock. What is its WACC?
(Hint: you need to calculate the cost of debt and the cost of equity first)
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Answer
First, you need to calculate the cost of debt by calculating the YTM on the bonds.
Input the following info into the calculator:N: 25; PV: -936.49; PMT: 75; FV: 1000; I/Yr: ?= 8.10%This is the before tax cost of debt. Calculate the
after-tax cost of debt:8.1% * (1-.40) = 4.86% …… cont.
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Answer
Next, calculate the cost of equity capital using the CAPM:
6% + 1.5(5.0%) = 13.5%
Lastly, you solve for WACC:.30(4.86%) + .70(13.5%) =10.91%
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Example
You were hired as a consultant to Locke Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7.0%, the cost of retained earnings is 11.50%, and the tax rate is 40%. The firm will not be issuing any new stock. What is the firm’s WACC?
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Answer
First, calculate the after tax cost of debt:7.5 * (1-.40) = 4.50%
Next, chart it outWeights After tax
costs
Debt 40% 4.50%
Preferred 10% 7.0%
Common 50% 11.50%
WACC = .40(4.5%) + .10(7%) + .50(11.50%) = 8.25%
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Example
To help finance a major expansion, Dimkoff Development Company sold a bond several years ago that now has 20 years to maturity. This bond has a 7% annual coupon, paid quarterly, and it now sells at a price of $1,103.58. The bond cannot be called and has a par value of $1,000. If Dimkoff’s tax rate is 40%, what component cost of debt should be used in the WACC calculation?
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Answer
Solve for I/Yr as you did in previous examples: (This is paid quarterly so you adjust the numbers for
annual)PMT: 7% * 1,000 = $70 (adjust for quarterly) = 17.50Years: 20 ( *4 because it is quarterly) = 80PV: -1103.58FV: 1000I/Yr: ? (multiply by 4) = 6.1% (this is before tax cost of debt, calculate after-tax)= 6.1 * (1-.40) = 3.66%
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Example
A company’s perpetual preferred stock currently trades at $80 per share and pays a $6.00 annual dividend per share. If the company were to sell a new preferred issue, it would incur a flotation cost of 4%. What would the cost of that capital be?
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Answer
First, calculate the cost after floatation cost: (hint: set it up like the after-tax cost of debt)
$80 * (1-.04) = 76.80 Next, use the formula for the cost of preferred
stock: Cost of preferred stock= rP = DP/PP
6/76.80 = ?= 7.81%
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Example
Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D1 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach?
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Answer
You are using the CGM approach formula:Po = D1(r – g)Using the information given in the question, you
set up the formula as: r = (D1/Po) + g1.00/25 + .06 = ?= .10 (10%)