# BUA321 Chapter 9 Class notes Cost of capital ```BUA321 Chapter 9 Class notes
Cost of capital
feature=player_detailpage&amp;v=JKJ
glPkAJ5o
Financing
• Why do companies need money?
• Describe the differences between
the capital structure and the
financial structure.
• What are the four sources of
long-term capital?
Risk and financing
• What is financial risk?
• What is the impact on the costs
of financing?
• What does flotation cost mean
for financing?
Capital structure
• A company has the following capital structure:
– What is the market capital structure?
Debt
30,000 bonds selling at par.
Preferred Stock
300,000 shares at \$90.
Common Equity
500,000 shares at \$87
Market Value
Debt
Preferred Stock
Common Equity (RE)
Common Equity (NEW)
Total Market Value
Weights
\$30,000,000.00
\$27,000,000.00
\$43,500,000.00
\$100,500,000.00
29.85%
26.87%
43.28%
Cost of Debt
• A company is contemplating issuing
30-year, 6% coupon bonds with a
par value of \$1,000. Suppose
further that the firm must sell the
bonds at \$970. Flotation costs are
3% or \$30. The corporate tax
bracket is 40%. What is the cost of
debt?
Bond
Coupon
N
Price
Flotation Costs (\$)
Tax Rate
Par Value
Preferred Stock
6.00% Dividend
30 Price
\$970.00 Flotation Costs (\$)
\$30.00
40.00%
\$1,000
Market Value
Weights
Debt
\$30,000,000.00
Preferred Stock
\$27,000,000.00
Common Equity (RE)
\$43,500,000.00
Common Equity (NEW)
Total Market Value
\$100,500,000.00
Cost of Debt (if given)
Cost of Debt (before tax)
Cost of Preferred
Cost of RE (DIV)
Cost of RE (SML)
Cost of New CS
After-Tax Cost
29.85%
26.87%
43.28%
3.87%
0.00%
#DIV/0!
#DIV/0!
6.46%
0.00%
#DIV/0!
0.00%
#DIV/0!
Cost of Preferred Stock
• A corporation is issuing preferred
stock. The dividend will be fixed
at \$7.50 and sell at a price of \$85.
Flotation costs are \$4.00. What is
the cost of Preferred Stock?
Bond
Coupon
N
Price
Flotation Costs (\$)
Tax Rate
Par Value
Preferred Stock
6.00% Dividend
30 Price
\$970.00 Flotation Costs (\$)
\$30.00
40.00%
\$1,000
Cost of Debt (if given)
\$7.50 Cost of Debt (before tax)
\$85.00 Cost of Preferred
\$4.00 Cost of RE (DIV)
Cost of RE (SML)
Cost of New CS
6.46%
9.26%
#DIV/0!
0.00%
#DIV/0!
Cost of Equity – RE and New CS
• The corporation must raise equity. The company
recently paid 4.75 in dividends. Historically
dividends have grown at 8%. The company
anticipates that this will continue. The most
recent price for the stock has been \$87.
Flotation costs have been \$2, but the company
anticipates an additional \$2 in underpricing. The
risk free return is 3.75; beta is 1.25; and the
stock market average is 11%. What is average
cost of retained earnings? The cost of new
Common Stock?
Common Stock
Div (D0)
Growth
Price
Flotation Costs (\$)
Risk Free Rate
Beta
Km
Div (D1) (if given)
Bond
Coupon
N
Price
Flotation Costs (\$)
Tax Rate
Par Value
\$
Preferred Stock
6.00% Dividend
30 Price
\$970.00 Flotation Costs (\$)
\$30.00
40.00%
\$1,000
Market Value
Weights
Debt
\$30,000,000.00
Preferred Stock
\$27,000,000.00
Common Equity (RE)
\$43,500,000.00
Common Equity (NEW)
Total Market Value
\$100,500,000.00
\$4.75
8%
\$87.00
4.00
4%
1.25
11%
Cost of Debt (if given)
\$7.50 Cost of Debt (before tax)
\$85.00 Cost of Preferred
\$4.00 Cost of RE (DIV)
Cost of RE (SML)
Cost of New CS
After-Tax Cost
29.85%
26.87%
43.28%
3.87%
9.26%
13.35%
14.18%
6.46%
9.26%
13.90%
12.81%
14.18%
Marginal Cost of Capital
• The company has determined that
they can borrow up to \$40 million
before the cost of debt would increase
to 7.5% before taxes. The company
forecasts that next year they will have
approximately \$20 million in retained
earnings. Determine the marginal costs
of capital for the firm.
Break Point
Amount Until Break
Break Point
Debt
\$40,000,000
Retained Earnings
\$20,000,000
First Tier
Break Pt (no debt BP, no RE)
Break Pt (debt BP &lt;= EQ BP)
Break Pt (Debt BP &gt; EQ BP)
Final Break Point
New After Tax Cost
Div (D0)
4.35% Growth
Price
Flotation Costs (\$)
Risk Free Rate
Beta
9.78%
Km
9.92%
Div (D1) (if given)
\$134,000,000
\$46,206,897
9.42%
\$
\$4.75
8%
\$87.00
4.00
4%
1.25
11%
_detailpage&amp;v=31ZwhL4pgJw
BUA321 Chapter 9 research 25 points
• Using your company what is the market value capital
structure? Use the book value of debt as the market value.
• From the stock valuation chapter, what is the dividend and
SML cost of retained earnings?
• Assume a \$5 flotation cost for new equity. What is the cost of
new equity?
• Predict a 5% increase in revenues next year. Given this
forecast, what is your predicted retained earnings next year?
Use this for the break point of equity costs.
• What is the WMCC for the firm?
BUA321 Exercise 33 points
• Complete the following table: The current
corporate tax rate is 40%.
Bond
Coupon
Maturity
Price
Flotation costs
A
10
15
1050
20
B
4
20
1000
30
C
7
30
975
15
Before tax Cost
of debt
After tax cost of
debt
• Complete the following table for costs of financing
The current corporate tax rate is 40%. (6 points)
Preferred
stock
Dividend
Price
Flotation costs
A
\$3
\$97
\$3
B
\$4.75
\$75.75
\$2.50
C
\$7
\$59
\$1.75
Before tax Cost of
preferred
After tax cost of
preferred
• Complete the following table The current
corporate tax rate is 40%. (9 points)
Stock
Dividend
Price
Growth
rate of
dividends
Flotation costs
A
\$1.75
\$60
4%
\$2
B
\$2.95
\$80
6%
\$1.75
C
\$3.85
\$25
3.75%
\$1
Before tax
Cost of
retained
earnings
Before tax
cost of new
common stock
After tax cost
of new
common stock
WACC
• Using the securities above calculate the WACC
for the following companies.
• Company A finances its cash needs with 30%
debt, 40% preferred stock, and 30% equity.
– WACC with RE
– WACC with new common stock
• Company B finances its cash needs with 60% debt,
10% preferred stock, and 30% equity.
– WACC with RE
– WACC with new common stock
• Company C finances its cash needs with 20% debt,
5% preferred stock, and 75% equity.
– WACC with RE
– WACC with new common stock
•
•
•
Complete the following
comprehensive cost of capital
problem.
Debt – The company is issuing 150,000 AAA rated bonds for \$975. The bonds have
a 30 year maturity and a 6.75% coupon. The average flotation costs for bonds is
\$10. The company’s corporate tax rate is 40%. If the company were to need
\$200,000,000 of debt the after-tax cost of financing would increase 2%.
Preferred stock will be issued with a 5.25% dividend and a stock price of \$85. The
company is considering issuing 600,000 shares. The flotation costs are estimated
to be \$2. There is no additional increase in costs if the firm decides to issue more
preferred.
New common stock will be issued with a projected dividend of \$3.75. The current
stock price is \$120. The company’s earnings and dividends have been growing
historically at 6% The company is estimating that 2,000,000 shares will be issued
with a \$1 underpricing cost and a \$2 underwriting fee. Retained earnings are
expected to be \$500,000,000.
Calculations
•
•
•
•
•
What is the after-tax cost of debt?
What is the after-tax cost of preferred?
What is the cost of retained earnings?
What is the cost of new common equity?
What is the capital structure of the financing? (what are the
proportions?)
• What is the break point of debt?
• What is the breakpoint of equity?
• Calculate the WMCC at the breakpoints.
```