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The Cost of
Sources of capital
Capital
Component costs
WACC
Cost of Capital
Long-Term Debt
Long-Term Debt Preferred
Preferred Stock
Stock Common
Common Stock
Stock
Retained Earnings
Retained Earnings New Common
New Common Stock
Stock
Calculating the weighted
average cost of capital
WACC = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
T = tax rate =
40%
Cost of debt
What is the current cost of debt for a
firm that has a 9% coupon bond with 5
years to maturity and a current price of
$962?
What is the after tax cost if it is in the
40% tax bracket?
Component cost of
preferred stock
WACC = xdkd(1-T) + xpkp + xcskcs
kp = Dp / Pp
= $8 / $111
= 7.2%
Component cost of
preferred stock
Preferred
dividends are not
tax-deductible, so no tax adjustments
necessary.
Component cost of equity
WACC = xd(pretax kd)(1-T) + xpkp + xcskcs
r = kcs
Average 10.4%
Calculate WACC
If 40% of your financing is from debt at
an after tax cost of 8% and 60% is from
pref. stock at 10%, what is the WACC?
It will be between what two numbers?
40% (.08) + 60% (.10)
.032 + .06 = .092
9.2%
Balance Sheet
use costs that were just calculated
Market values
Stock 6,000
= 8.7%
WACC
You are analyzing the cost of capital for
a firm that is financed with 60 percent
equity and 40 percent debt. The after-
tax cost of debt capital is 10 percent,
while the cost of equity capital is 20
percent for the firm. What is the overall
cost of capital for the firm?
(.6 x .2) + (.4 x .1) = 16%
Equity + Debt
Cardinal Health has bonds outstanding
with 15 years to maturity and are
currently priced at $800. If the bonds
have a coupon rate of 8.5 percent, then
what is the after-tax cost of debt for
Beckham if its marginal tax rate is 30%?
7.9%
Should the company use the
composite WACC as the hurdle rate
for each of its projects?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm. Therefore, the WACC only
represents the hurdle rate for a
typical project with average risk.
Different projects have different risks.
The projects WACC should be adjusted
to reflect the projects risk.
Optimum Capital Structure
Theoptimal (best) situation is associated with the
minimum overall cost of capital:
Optimum capital structure means the lowest WACC
Usually occurs with 30-50% debt in a firms capital
structure
WACC is also referred to as the required rate of
return or the discount rate
Optimal Capital Structure
Cost (After-tax) Weights Weighted
Cost
Financial Plan A:
Debt 6.5% 20% 1.3%
Equity. 12.0 80 9.6
10.9%
Financial Plan B:
Debt 7.0% 40% 2.8%
Equity. 12.5 60 7.5
10.3%
Financial Plan C:
Debt 9.0% 60% 5.4%
Equity. 15.0 40 6.0
11.4%
Cost of capital curve