CHAPTER 8The Cost of Capital

11/16/97

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CHAPTER 8The Cost of Capital

What sources of capital should be included in a firm’s WACC?

Should we focus on before-tax or after-tax capital costs?

Should we focus on historical (embedded) costs or new (marginal) costs?

What’s kd? Coupon = 12% semi; Price = $1,153.72; 15 years.

Component cost of debt

What’s the cost of preferred stock? Pps = $113.10; 10%Q; Par = $100; F = $2.

Picture of Preferred

Is preferred stock more or less risky to investors than debt?

Why is yield on preferred lower than kd?

Why is there a cost for retained earnings?

Three ways to determine cost of retained earnings, ks:

What is the cost of retained earnings based on the CAPM?kRF = 7%, MRP = 6%, b = 1.2.

What’s the DCF cost of retained earnings, ks? Given: D0 = $4.19; P0 = $50; g = 5%.

Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.What’s the expected future g?

Retention growth model:g = b(ROE) = 0.35(15%) = 5.25%.Here b = Fraction retained.Close to g = 5% given earlier. Think of bank account paying 10% with b = 0, b = 1.0, and b = 0.5. What’s g?

Could DCF methodology be applied if g is not constant?

Find ks using the own-bond-yield-plus-risk-premium method. (kd = 10%, RP = 4%.)

What’s a reasonable final estimate of ks?

How do we find the cost of new common stock, ke?

Why is ke > ks?

What is the WACC using only RE for equity component of WACC1?

WACC with new CS

Summary to this point

Define the MCC schedule.

How large will capital budget be before company must issue new CS?

Find retained earnings break point.

Investment Opportunities(Capital Budgeting Projects)

Would the MCC remain constant beyond the RE breakpoint?

Author: Shana Lum