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Topics Covered
Geothermals Cost of Capital
Weighted Average Cost of Capital (WACC)
Capital Structure
Required Rates of Return
Big Oils WACC
Interpreting WACC
Flotation Costs
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Cost of Capital
Cost of Capital - The return the firms
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firms mix of long
term financing and equity financing.
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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).
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WACC
Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of
all the firms securities.
Company cost of capital = Weighted average of debt
and equity returns.
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WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a
proportion of the firms market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.
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WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.
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WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.
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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
WACC =
4
12
] (
x(1-.35).06 +
2
12
) (
x.12 +
6
12
=.123 or 12.3%
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x.18
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rd = YTM
Common Stock
re = CAPM
= rf + B(rm - rf )
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Div1
P0 =
re - g
solve for re
Irwin/McGraw Hill
Div1
re =
+ g
P0
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights
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P0 =
Div1
rpreferred
Irwin/McGraw Hill
Div1
=
P0
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Flotation Costs
The cost of implementing any financing
decision must be incorporated into the cash
flows of the project being evaluated.
Only the incremental costs of financing
should be included.
This is sometimes called Adjusted Present
Value.
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Problems
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Problems
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Problems
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Problems
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Problems
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Problems
Common: New common stock would have a
floating cost of 10 percent.
Preferred: New preferred could be sold to the
public at a price of $ 100 per share with the
dividend of $11, Floating cost of $ 5 would be
incurred.
Debt: New debt could be sold at an interest rate of
12 percent.
Find the component cost debt, preferred stock,
retained earnings and new common stocks?
What is the WACC?
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