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Sources of Capital
Component Costs
WACC
Adjusting for Flotation Costs
Adjusting for Risk
10-1
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
What sources of capital do firms use?
Capital
Preferred Common
Debt
Stock Equity
10-2
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Calculating the Weighted Average Cost of Capital
10-3
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Should our analysis focus on before-tax or after-
tax capital costs?
10-4
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Should our analysis focus on historical (embedded)
costs or new (marginal) costs?
10-5
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
How are the weights determined?
10-6
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview of Coleman Technologies Inc.
10-9
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A 15-year, 12% semiannual coupon bond sells for
$1,153.72. What is the cost of debt (rd)?
10-10
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Component Cost of Debt
10-11
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Component Cost of Preferred Stock
10-12
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What is the cost of preferred stock?
rp = Dp/Pp
= $10/$111.10
= 9%
10-13
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Is preferred stock more or less risky to investors
than debt?
10-14
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Why is the yield on preferred stock lower than
debt?
10-15
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Component Cost of Equity
10-16
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Why is there a cost for retained earnings?
10-17
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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
10-18
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Find the Cost of Common Equity Using the
CAPM Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
10-19
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
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%
10-20
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Can DCF methodology be applied if growth is
not constant?
10-21
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Find rs Using the Bond-Yield-Plus-Risk-Premium
Approach
rs = rd + RP
rs = 10.0% + 4.0% = 14.0%
10-22
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
What is a reasonable final estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8
rd + RP 14.0
10-23
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Why is the cost of retained earnings cheaper
than the cost of issuing new common stock?
10-24
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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%
10-25
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Flotation Costs
10-26
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Ignoring flotation costs, what is the firm’s WACC?
10-27
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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.
10-28
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Should the company use the composite WACC as the
hurdle rate for each of its projects?
10-29
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Divisional Cost of Capital
9-30
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