1. 1 FINC3131 Business Finance Chapter 10: The Cost of Capital

2. Capital Components 2 Capital Debt Preferred Stock Common Stock

3. weighted average cost of capital (WACC) WACC = w d r d (1-T) + w e r e 1.The w’s refer to the firm’s capital structure weights. 2.The r’s refer to the cost of each component.

4. Component cost of debt WACC = w d r d (1-T) + w e r e 1.r d is the cost of debt capital. 2.The yield to maturity on outstanding L-T debt is often used as a measure of r d. 3.Why tax-adjust, i.e. why r d (1-T)?

5. focus on after-tax capital costs Because interest is tax deductible.

6. A 15-year, $1000 face value,12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (r d )? Remember, the bond pays a semiannual coupon, so r d = 5.0% x 2 = 10%. INPUTS OUTPUT NI/YRPMTPVFV 30 5 601000 -1153.72

7. Component cost of equity WACC = w d r d (1-T) + w e r e 1.r e is the cost of common equity

8. Two ways to determine the cost of common equity, r e 1.r e = r RF + bx(r M – r RF ) 2. r e = (D 1 / P 0 ) + g

9. If the r RF = 7%, RP M = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? r e = r RF + (r M – r RF ) b = 7.0% + (6.0%)1.2 = 14.2%

10. If D 0 = $4.19, P 0 = $50, and g = 5%, what’s the cost of common equity ? D 1 = D 0 (1 + g) D 1 = $4.19 (1 +.05) D 1 = $4.3995 r e = (D 1 / P 0 ) + g = ($4.3995 / $50) + 0.05 = 13.8%

11. what is the firm’s WACC? If weight of debt =40%, weight of equity =60%, cost of debt=10%, cost of equity=14%, tax rate=30%, WACC= w d r d (1-T) + w e r e = 0.4(10%)(1-0.3) + 0.6(14%) = 0.028 + 0.084 = 0.112=11.2%

12. Assignment 1.problems: 10-1 10-3 10-8 10-9 12