Lecture "Fundamentals of finance management - Chapter 9: The cost of capital" has contents: What sources of long-term capital do firms use, how are the weights determined, component cost of debt, component cost of preferred stock,.and other contents. | CHAPTER 9 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock Calculating the weighted average cost of capital WACC = wdkd(1-T) + wpkp + wcks The w’s refer to the firm’s capital structure weights. The k’s refer to the cost of each component. Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, . use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible. Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). How are the weights determined? WACC = wdkd(1-T) + wpkp + wcks Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? Component cost of debt WACC = wdkd(1-T) + wpkp + wcks kd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of kd. Why tax-adjust, . why kd(1-T)? A 15-year, 12% semiannual coupon bond sells for $1,. What is the cost of debt (kd)? Remember, the bond pays a semiannual coupon, so kd = x 2 = 10%. INPUTS OUTPUT N I/YR PMT PV FV 30 5 60 1000 Component cost of debt Interest is tax deductible, so A-T kd = B-T kd (1-T) = 10% (1 - ) = 6% Use nominal rate. Flotation costs are small, so ignore them. Component cost of preferred stock WACC = wdkd(1-T) + wpkp + wcks kp is the marginal cost of preferred stock. The rate of return investors require on the firm’s preferred stock. What is the cost of preferred stock? The cost of preferred stock can be solved by using this formula: kp = Dp / Pp = $10 / $ = 9% Component cost . | CHAPTER 9 The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock Calculating the weighted average cost of capital WACC = wdkd(1-T) + wpkp + wcks The w’s refer to the firm’s capital structure weights. The k’s refer to the cost of each component. Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, . use A-T costs of capital in WACC. Only kd needs adjustment, because interest is tax deductible. Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). How are the weights determined? WACC = wdkd(1-T) + wpkp + wcks Use accounting numbers
