Chapter 6,7 c) rnriltr lnvestor Er:.

r:irrufi'u
Chapter 11 .) uvrdr:rrilu tne issuer Q Eia.:nr:tiuorn investor
Ed^

ffiff
Cost of Gapital 10olo
-,f'.""*";1 ctR', "@
Requlred rate of relurn 10%

tt fiolr6u inlereef
)
Z Etock
m?r Prefsrrcod I
|) 6a$ru dtvtdend Pls
A. Cornrnon Equfty t
c) aan New comrnon stock
r ff
II fia$ru divrdend c/s
c) fm Retatned Earnhg tn'li f t J oppo.turrny cosf ot extattng C/S hotaer
(Eaming not paid out jn dividend to C/S shareholders)

COST Otr CAHITAL = cosr flu€fnfiarrfid*nrtrrtiuura.rqu

= Cosl *hai comPany has +o p+7 for opporfu*ty cosl of investor's fund
+ Minirnum rafe +hEt {he Co. mus} earn fo suvive
tudanHarirrrfuEirdutsfnfi a.:-tfi tfianrtla{:aol

fnlemal rate of r,efurn > Cost oF caFlal I Shareholder's weaHh Increase

l. Cosl of bond + in{eres{ expense is tax deduc{ible

2. Cosl of capi*al musl include Floala*ion cosf

o Floatation Cost or Underwriting Fee

lhe underwri'ier's spread and issu;ng cos*s associaled wi-fh the issuance
and marke*ing of new securilies
trirtferutunr:aan Bond, P/S, c/S) .

13
I
I. F;nd ouf We;ght of t-T debf. P/S and Gonrron Equ;fy
Weighf is the proportion of the total financing raised from each source.
tr Capital Struclure 1L-T sources of funds) =LTD+PS+ClE
1 Weight of L-T debt (Bond) f f Wd (Zo_)

2- Weight of P/S ff wp(%)

3. Weight of CIE f| Wc(%)
IOOVa

If. Gosf of Deff (fd) c) cost dsE6nfiasrfig lgrn{ror

(f) YTI'I tBefore fax hd)
J+lnterest=CxM
Find YTM (Kd) : I + 1.000-Np C Coupon rate
'
n MI Par= l,(XX)
@ 2
n + no- ofyear

* wh"re Np (Nei proceed) - Price - Floalation Cosl

* Real'amount of money co. get. 1ri*qr#u3b1ilciornnr:aan)
':
2. yirtri'rilu after-tax Kd' = Kd (l-T; *.-'

III.' GOST or P/$ (fp) + s"'t iiueriufiaoi$g lt*r"rn prs

DP x 100
(P-F)

6 DP | | prvroend. on P/8 #aorirrflu $ uacrifu :rsitraua

IV. Cosf of Gonnon Eguify (Kr & Knc)

tl Common Equity can be obtainbd from
1.1 (intemal)| Retained eaming ff rordrl:s:srr olu3uywrld
1.2 (extemal) ) lssue new common stocks.

AAETHOD 1: CON5TANT-6ROWTH DIVIDEND MODEL

Use when dividend is expected to grow the constant rate forever

A. Infernal C/E (Kr) = cost of using retained eamins

(Not issue new C/S I no floatation cost)

Kr = DI+g
P X 100

l4
 sDl r) expffted dividend of ffris year llSurt"uHndnra'iro;1dtufl d1
f) Dl = Do (1+g)
oo I riurJuHara.:iJdu#:
Sg |f growth rate

Exfernal C/E (Kne) = cost of new C/S (must pay floatation)

Knc = DI +g X 100
Np

METHOD ): CAPITAL A55ET PRlClN6 MODEL ((Aprrr)

- Rf I risk-free rate
Kc = Rf + I (Kr" -- Rf) - Km i market retum

' The CAPM explicitly considers thq firm's r,isk as reflected in bela.

' Dividend valuation modet does not explicitly consider risk- ,

' CAPM can easily be adjusted for flotation costs when estimating the cost of new equity-

V. Weiqhf Aver

' The average'of the after-tax costs of each of the sourq€s of capital use by a firm.
(r1nor-rr[l* 7e gruri'ura5aufr nr: too aieqy

c: WACC (int.) - (Wd x afrer-fax Kd) + (Wp x Kp) + (We x Kr)

tr WACC (exl.)= (Wd x afrer-fax Kd) + (Wp x Kp) + (Wc x Knc)
ECONOIVII( VAIE ADDED (EYA)
EVA is a popular measu-re used by firms to determine whether an investment contributes to
owners'wealth-

lf. EVA (+) t accept project

rf FVA (-) + reject project

Ex. An invesffnent of $3.75 million by a firm with a WACC ot 1}o/o in a project expected to generate NOPAT cf
$410,000. Find EVA

l5
 The WACC typically increases as the volume of new capital raised within a given period-

Volume of financing I I Suppliers of fund required return i I cost of capital i

Step 1: Find Break Points I level of total new financing at which the cost of one of the financing
components rises.

BP= breaking point form financing source

AF= amount of funds available at a glven cost
w target capital structure weight for source

Ex. The firm has $2 million of retained earnings available (cost 15.8%). 'When it is exhausted, the firm must
issus new (more expensive) equity (cost 16%)- Furthermore, the company can bonow only $1 million of cheap
debt at 5.67% eost after tax. Additional debt will have an after-tax cost 7%
4tr/o
Prefened stock 1O%
Common stock i9l'
1CIJVO

Slep 2: Find WACG over each break point

Range of toIal. Soqrce of Weighbd

New Flnancing Gapltal YYelsht Gost Cost
$0 tq $Z.S million DebJ 40% 5.670/o 2.2ffi%
Prefened 10% 9.62% A-$i?./o
Common 5f/, 15.80% 7.900/0
wAcc 11-lWo

92.6 to $4.0 miltion Debt 40% 7.OO% 2.BAA%

Prefened 10o/o 9.620/o 0.962%
Common so% 15.80% 7.9A0%
wAcc 11.ffi?/o
over $4.0 mlllion Debt 4$o/o 7-OO% 2-8Wt/L
Prefened 1Oo/o 9.62% 0.9620/o
Common 50% 16.@Yo 8.(F0o/o
wAcc 11.767/o

t6
Step 3: Graph m[CC schedule
wAcc

Total Financing
(millions)

- A ranking of investrnent possibilities fiom best (highest retum) to worst (lowest retum)
- First projec-t selected witl have the highest retum and next second highest.

- Retum on investments will decrease as the firm accepts additioiial projects.

Ex-
Initial Cumulative
Project IRR lvestment lnvestment
A 13_O% $ 1,000,000 $ 1,000,000
B 12.Oo/o $ 1,000,000 $ 2,000,000
c 11.5% $ 1,000,000 $ 3,000,000
.D. 11.O% $ 1,000,000 $ 4,000,000
E 10.0% $ 1,000,000 $ s,oodr,ooo

llo%l
@ ilroao
a
a
a
.6

aa a a o a
a
a
a
a
t
a
a
a
'a
a
a
.a

aa

$1,0 $2.0$2.6$3.0 $4.0 Total Financing

(millions)

t7
 qO.STOFGAP]TAL

It Frxp our tt'uenr (96) ofLTD (Wd),

Weight of P/S (Wp), weight of CIE (Wc)

2. Eoxp yTrr + 1,000-XP

N
1.000 +|rP
2
AfTER TA)I rd = rd(l-t)
!1. Itp tt
a DB r IOO
"1r Xp
A. DIVIDEXD GROIYTH
4. GlE
Internal* ltr=
#*t
Externallltnc E +g
= }{P
B. CAPM
lic : Rf+B(Km-R0
5. I*ACC (inQ (Wd x a/t Kd) + (Wp x Kp) +twc x Klf
WACC (ext) twd x a/t t<d) + (Wp x Kp) +(We x Kne)
Growth rate (gl l" historical dividend
2. g-ROFxVETo
Refurn on Equilg =, fll x IOO Retained Earning (7o]
(RoEl TE (RlE 7o) Nl

Np = P-F Dl = Do (l+g)
NOTE:
a/r !(d
r-ta^6 r. rr t^rl^A I rt
YufiriEi [m?, <- En'AUU [8]ct,

18
Dillon t^abs has asked its financial manager to measure the cost of each specific type of capital
as well as the weight average cost of capital.
Debt 40%
Preferred stock 10%
Commonstock 50%
100%

Debt:
Short term: Six month bank loans are available at l2Yo (APR)
Long term: The firm can raise unlimited amount of debt by selling $1000 par value bond,
with 10 year maturify with annual interest at a l0Ya coupon rate. To sell this bond, a
floatation cost of 3o/o of the par value is required in addition to the discount of $ 20 per
bond. (Tax is 30%)

Preferred Stock The firm's preferred stocks pay dividend 2Yo per quarter and have a par
value of $ 100 per share. It could be currently sold for $65 per share- An additional fee of $2
per share must be paid to the underwriters if the firqr wants to issue new same p/s-

Common Stock: The firm's c/s is currently selling for $50 per share- Its dividend pa5mtents,
which have been approximately 6AYoof earning per ihare in the past 5 years and expected to be
same in the future, were as shown below-

Year Dividend
2002 $2.8s
2003 $3.15
2004 $3.30
2005 $3.50
2406 $3.75

The firm is expected that to sell new issue, c/s must be under-priced by $5 per share and the
fimr must also pay $3 per share in floatation cost.

a. Calculate the cost of capital of this firm (WACC) if it wishes to raise additional capital.

b. If invesknent in projects A,B and C give the internal rate of return (IRR) of 2lo/o, ltYo and
l0olo ,which projects should be accepted

c. If earnings available to common shareholders are expected to be $7 million, what is the

break point associated with the exhaustion of retained earnings?

d. Determine the WACC between zero and the break point calculated in part c.

e. Deterrnine the WACC just beyond break point calculated in part c.

t9
Problem 2
Humble Manufacturing is interested in measuring its overall cost of capital. The frm is in the 40% tax-
Cunent investigation has gathered the following data:

Debt: The frm can raise an unlirnited amount of debt by selling $1,000-par value, l0olo coupon
interest rate, l0 year bonds on which annual interest payment will be made. To sell the issue, an averurge
discount of $30 per bond must be given. The firm must also pay floatation cost $20 per bond.

Preferred stock The firm can sell l1% (annual dividend) prefened stock at its lO0-per-share par
value. The cost of issuing and selling the preferred stock is expected to be $4 per share. An unlimited
amount of preferred stock can be sold under these terms.

Common stock: The firrn's common stock is currently selling for $80 per share. The firm expects to pa
cash dividends of $6 per share next year. The firm's dividends have been growing at an annual rate of
6Yo, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per
share, and floatation costs are expected to amount to $4 per share. The firm can sell an unlimited
amount of new common stock under these terms.

Retained earnings: The firm expects to have $225,000 of retained eamings available in the coming
year. Once these retained earning are exhausted, the firm will use new common stock as the form of
conmon stock equity financing.

a. Calculate the specifie cost of each sourc€ of financing

b. The firm uses the weight shown in the following table, which are based on target capital
structure proportions, to calculate its weight average cost of capital
Source of Caoital Weisht
Long-term debt 4A%
Preferred stock lsYo
Common stock equi8 45o/o
Total t00%
(1) Calculate the single break point assooiated with the firm's financial situation (flint: This
point results from the exhaustion of the firm's retained earnings)

(2) Catcutate the weight average cost of capital associated with.total nerv financing below the
break point calculated in part (l)

(3) Calculate the weight average cost of capital associated with total new financing above the
break point calculated in part (1)

Using the results of part b along with the information shown in the following table on the
available investment opportunities; draw the firm's weight average cost of capital (WMCC)
schedule and inveshnent opportunities schedule (IOS) on the same set of axes (total new
financing or invesfinent on the X axis and WACC and IRR on the y axis)
f nvestment oonortunitv Internal rate ofreturn Initial Investment
A ll.zYo $100,000
B 9.7% 500,000
'c 12.9% 150,000
D 16.5Yo 200,000
E 11.8% 450,000
F t0.t% 600,000
G r0.5% 300.000

d. Which, if any, of the available investments do you recommend that the firm accept?
Explain your answer. Horv much total new financing is required?

20