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CHAPTER 10The Cost of Capital
Sources of capital
Component costs
WACC
Adjusting for flotation costs
Adjusting for risk
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What sources of long-term
capital do firms use?Long-Term
Capital
Long-TermDebt
PreferredStock
CommonEquity
RetainedEarnings
New CommonStock
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Weighted Average Cost of
Capital (WACC) The weighted average of the
component costs of debt, preferredstock and common equity.
The ws are all weights of different components. The rs are allthe rate of return to be paid to the investors. T is the tax rate.
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Should our analysis focus onhistorical (embedded) costs or new
(marginal) costs?
The cost of capital is used primarily tomake decisions that involve raising new
capital. So, focus on todays marginalcosts (for WACC).
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Cost of debt, rd The quoted interest rate the firm must pay on
new debt.
After tax cost of debt is used, rd(1-T). As interest is tax-deductible, the firm is
getting a tax advantage by taking on debt.Thus the tax advantage is taken into accountwhile calculating the cost of debt.
In effect the government is paying part of thecost.
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Cost of Preferred Stock, rp The rate of return investors require on
firms preferred stocks.
rp = Dp/Pp Preferred dividends are not tax-
deductible, so no tax adjustments
necessary.
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Cost of Equity, rs Equity has two components: Retained
earnings & common stocks
Cost of retained earnings = opportunitycost of investing in more stocks i.e.required rate of return
Cost of common stocks = required rate ofreturn and floating cost of the firmsshares.
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Methods of calculating rs CAPM approach, r = rRF + (rM + rRF)b
Bond yield plus risk premium of 3% to
5%. This approach is very subjective based on
empirical studies
Dividend yield plus expected growthrate, r = (D1/P0) + g
Final estimate of rs is the average of all
the alternative estimates
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Flotation costs The percentage cost of issuing new common stock
given to investment bankers or brokers.
It is usually adjusted with the required rate of returnto find the cost of equity.
Flotation costs depend on the risk of the firm and thetype of capital being raised.
The flotation costs are highest for common equity.However, since most firms issue equity infrequently,the per-project cost is fairly small.
We will frequently ignore flotation costs when
calculating the WACC.
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Floatation Cost Adjustment The amount that must be added to
estimated rs to account for floatation
cost.
F = Floatation cost per share
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Factors affecting WACC Factors firm cannot control
Interest rates in the economy
General level of stock prices
Tax rates
Factors that firm controls
Capital Structure
Dividend payout ratio
Capital Budgeting decisions
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