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Chapter
Cost of Capital
McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
Cost of capital and its importance Discount rates used to analyze investments Valuation and application to bonds, preferred stock, and common stock Minimum cost of capital Increase in cost of capital with increase in utilization of finances
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Cost of Capital
In corporate finance, an investment made is for an anticipated return in future
Knowing the appropriate discount rate is vital
Return on investments must, in the least, garner a return equaling the costs incurred to acquire it the minimum acceptable return
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Cost of Debt
Measured by interest rate, or yield, paid to bondholders
Example: $1,000 bond paying $100 annual interest 10% yield Calculation is complex discount rate or premium from par value bonds
20 .6 ($940) + .4 ($1,000)
= $101.50 + 60 20 $564 + $400 Y = $101.50 + 3 = $104.50 = 10.84% $964 $964
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Assuming:
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Preferred stock dividend is not a tax-deductible expense, with no downward tax adjustment
The proceeds to the firm equals selling price in the market minus flotation cost
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For ease of reference, = Cost of common equity in the form of retained earnings = Dividend at the end of the first year, $2 = Price of stock today, $40 g = Constant growth rate in dividends, 7% = $2 + 7% = 5% + 7% = 12% $40
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7.0% 12.5
40% 60
9.0% 15.0
60% 40
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To minimize cost of equity, a firm may sell common stock when prices are relatively high A balance between debt and equity is required to achieve minimum cost of capital
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Where X represents the size of the capital structure that retained earnings will support X = $23.40 million = $39 million .60
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Increase is because common equity is now in the form of new common stock rather than retained earnings The aftertax cost of the new common stock is more expensive than retained earnings because of flotation costs
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The $50 million figure can be derived thus: Z = Amount of lower-cost debt ; Percent of debt in the capital structure
Z = $15 million = $50 million .30 Where Z represents the size of the capital structure in which lower-cost debt can be used
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