Unit 7

Types of Capital Types of Capital Debt Preferred Stock Common Equity New Common Stock Retained Earnings

Weighted Average Cost of Capital (WACC) A weighted average of the component costs of debt, preferred stock, and common equity. WACC= (% of debt)(After-tax cost of debt) + (% of preferred stock)(Cost of preferred stock) + (% of common equity)(Cost of common equity)

CAPM & CGM This should be a review of the previous unit: CAPM: rs=rRF + bi (RPM) CGM: Po= D1/rs-g

Cost of Preferred Stock Cost of preferred stock= rP = DP/PP

Example Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Retained earnings for the coming year are expected to be $1,000,000, and the common equity ratio is 60 percent. If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises? r= (D1/P) + g r= (1.00 *1.06)/(20*(1-.20)) + .06 r= .0663 + .06 = .1263 (12.63%)

Example Suppose you were provided with the following data:  Target capital structure:  40% debt, 10% preferred, and 50% common equity.  The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%.  The firm will not be issuing any new stock.  What is the firm’s WACC?

Answer WACC= wdrd + wprp + wsrs Weight Cost Debt 40% 4% Preferred 10% 7.50% Common 50% 11.5% WACC= wdrd + wprp + wsrs WACC= .40(4%) + .10(7.50%) + .50(11.50%) = ? =8.10%

Example Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings. The current market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. Allison can issue new common stock at a 15 percent flotation cost. What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital?

Answer r= (D1/P) + g First, calculate the D1 2.20 * 1.06= 2.332 Next, calculate the price after flotation cost 28 * (1-.15)= 23.80 r= (2.332 / 23.80) + .06 r= 15.8%

Example You are a consultant to Pillbriar Company. Pillbriar’s target capital structure is 36% debt, 14% preferred, and 50% common equity. The interest rate on new debt is 7.8%, the yield on the preferred is 7.00%, the cost of retained earnings is 11.75%, and the tax rate is 38%. The firm will not be issuing any new stock. What is Pillbriar's WACC?

Answer First, calculate the after tax cost of debt: 7.8% * (1-.38) = 4.84% Next, chart it out Weights After tax costs Debt 36% 4.84% Preferred 14% 7.0% Common 50% 11.75% WACC = .36(4.84) + .14(7%) + .50(11.75%) = 8.60%

Example A company’s perpetual preferred stock currently trades at $85 per share and pays a $9.35 annual dividend per share.  If the company were to sell a new preferred issue, it would incur a flotation cost of 4%.  What would the cost of that capital be? 

Answer First, calculate the cost after floatation cost: (hint: set it up like the after-tax cost of debt) $85 * (1-.06) = 79.90 Next, use the formula for the cost of preferred stock: Cost of preferred stock= rP = DP/PP 9.35/79.90= ? = 11.70%

Example SW Ink's preferred stock, which pays a $5 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Ink's weighted average cost of capital (WACC)? r= D1 / P1 r = 5.00 / 62.50 r = 8%