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COST of CAPITAL SLIDE Semester 2 2020-2021 part 1.ppt
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- 2. Cost of Capital- Learning Goals 1. Understand the key assumptions, the basic concept, and the specific sources of capital associated with the cost of capital. 2. Determine the cost of long-term debt and the cost of preferred stock. 3. Calculate the cost of common stock equity and convert it into the cost of retained earnings and the cost of new issues of commons stock. 11-2
- 3. Learning Goals (cont.) 4.Calculate the weighted average cost of capital (WACC) 11-3
- 4. An Overview ofthe Cost of Capital The cost of capital acts as a link between the firm’s long-term investment decisions and the wealth of the owners as determined by investors in the marketplace. It is the “magic number” that is used to decide whether a proposed investment will increase or decrease the firm’s stock price. Formally, the cost of capital is the rate of return that a firm must earn on the projects in which it invests to maintain the market value of its stock. 11-4
- 5. The Firm’s CapitalStructure 11-5
- 6. Some Key Assumptions Business Risk—the risk to the firm of being unable to cover operating costs—is assumed to be unchanged. This means that the acceptance of a given project does not affect the firm’s ability to meet operating costs. Financial Risk—the risk to the firm of being unable to cover required financial obligations—is assumed to be unchanged. This means that the projects are financed in such a way that the firm’s ability to meet financing costs is unchanged. After-tax costs are considered relevant—the cost of capital is measured on an after-tax basis. https://youtu.be/ZiIFtmxt3vU Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-6
- 7. The Basic Concept(cont.) Why do we need to determine a company’s overall “weighted average cost of capital?” Over the long haul, the firm must undertake investments that maximize firm value. This can only be achieved if it undertakes projects that provide returns in excess of the firm’s overall weighted average cost of financing (or WACC). 11-7
- 8. Specific Sources ofCapital: The Cost of Long-Term Debt The pretax cost of debt is equal to the yield-to-maturity on the firm’s debt adjusted for flotation costs. Recall that a bond’s yield-to-maturity depends upon a number of factors including the bond’s coupon rate, maturity date, par value, current market conditions, and selling price. After obtaining the bond’s yield, a simple adjustment must be made to account for the fact that interest is a tax-deductible expense. This will have the effect of reducing the cost of debt. 11-8
- 9. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) 11-9 Brian Clara, a major Sport Goods Manufacturer, is contemplating selling $10 million worth of 20-year, 9% coupon bonds with a par value of $1,000. Because current market interest rates are greater than 9%, the firm must sell the bonds at $980 (Discount Bond). Flotation costs are 2% or $20. The net proceeds to the firm for each bond is therefore $960 ($980 - $20). Net Proceeds
- 10. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt The before-tax cost of debt can be calculated in any one of following ways: Calculating the cost Approximating the cost https://youtu.be/aP3ZLLxI-vk 11-10
- 11. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt Calculating the Cost This approach finds the before-tax cost of debt by calculating the internal rate of return (IRR). As discussed in earlier in the text, YTM can be calculated using: (a) trial and error, (b) a financial calculator, or (c) a spreadsheet. 11-11
- 12. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt Calculating the Cost 11-12
- 13. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) Before-Tax Cost of Debt Approximating the Cost 11-13
- 14. Specific Sources ofCapital: The Cost of Long-Term Debt (cont.) 11-14 Find the after-tax cost of debt for Duchess assuming it has a 40% tax rate: ri = 9.4% (1-.40) = 5.6% This suggests that the after-tax cost of raising debt capital for Duchess is 5.6%.
- 15. Specific Sources ofCapital: The Cost of Preferred Stock 11-15 Duchess Corporation is contemplating the issuance of a 10% preferred stock that is expected to sell for its $87-per share value. The cost of issuing and selling the stock is expected to be $5 per share. The dividend is $8.70 (10% x $87). The net proceeds price (Np) is $82 ($87 - $5). rP = DP/Np = $8.70/$82 = 10.6%