BUA321 CH09 Cost of Capital
BUA321 Chapter 9 Class notes Cost of capital
http://www.youtube.com/watch?feature=player_detailpage&v=JKJglPkAJ5o
1) Why do companies need money?
Expansion
Should they borrow to operate the business?
2) Describe the differences between the capital structure and the financial structure.
Financial Structure is all the right side
Capital structure is LT
3) What are the four sources of long-term capital?
Bonds
Preferred Stock
Equity
Common Stock
Retained earnings
4) What is business risk? What is financial risk?
Risk of the business and industry
Chosen when you choose the business
Risk of borrowing
Chosen as you do the business
5) What does flotation cost mean for financing?
6) A company has the following capital structure: use WACC to calculate
Debt
Preferred Stock
Common Equity
30,000 bonds selling at par.
300,000 shares at $90.
500,000 shares at $87
a) 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 to the public at $970.
Flotation costs are 3% or $30. The corporate tax bracket is 40%. What is the cost of
debt?
Content Coordinator: Dr. Lawrence Byerly
BUA321 CH09 Cost of Capital
Bond
Coupon
N
Price
Flotation Costs ($)
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
6.46%
0.00%
#DIV/0!
0.00%
#DIV/0!
After-Tax Cost
29.85%
26.87%
43.28%
3.87%
0.00%
#DIV/0!
#DIV/0!
b) 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
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)
$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!
After-Tax Cost
29.85%
26.87%
43.28%
3.87%
9.26%
#DIV/0!
#DIV/0!
c) 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
Content Coordinator: Dr. Lawrence Byerly
$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%
BUA321 CH09 Cost of Capital
d) 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.
Market Value
Debt
Preferred Stock
Common Equity (RE)
Common Equity (NEW)
Total Market Value
Amount Until Break
Break Point
$40,000,000
$20,000,000
First Tier
Break Pt (no debt BP, no RE)
Break Pt (debt BP <= EQ BP)
Break Pt (Debt BP > EQ BP)
Final Break Point
Weights
$30,000,000.00
$27,000,000.00
$43,500,000.00
After-Tax Cost
29.85%
26.87%
43.28%
3.87%
9.26%
13.35%
14.18%
$100,500,000.00
Common Stock
New After Tax Cost
Div (D0)
$134,000,000
4.50% Growth
$46,206,897
Price
9.42%
Flotation Costs ($)
Risk Free Rate
Beta
9.78%
Km
9.97%
Div (D1) (if given)
$
$4.75
8%
$87.00
4.00
4%
1.25
11%
Small business financing
i. http://www.youtube.com/watch?feature=player_detailpage&v=31ZwhL4pgJw
Content Coordinator: Dr. Lawrence Byerly
BUA321 CH09 Cost of Capital
Research (25 points) _______ Offline Homework (33 points) ______
BUA321 Chapter 9 research 25 points
1) Using your company what is the market value capital structure? Use the book value of
debt as the market value.
2) From the stock valuation chapter, what is the dividend and SML cost of retained
earnings?
3) Assume a $5 flotation cost for new equity. What is the cost of new equity?
4) 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.
5) What is the WMCC for the firm?
Content Coordinator: Dr. Lawrence Byerly
BUA321 CH09 Cost of Capital
BUA321 Exercise 33 points
1. Complete the following table for costs of financing with the use of debt. The current corporate tax
rate is 40%. (6 points) (use WACC spreadsheet, complete the questions below as parts, do part A
for the following problems and then answer question #4, then repeat for B & C)
Bond
Coupon
Maturity
Price
Flotation
costs
Before tax
Cost of debt
After tax
cost of debt
A
10
15
1050
20
9.61%
5.77%
B
4
20
1000
30
4.23
2.54
C
7
30
975
15
7.45
4.47
2. Complete the following table for costs of financing with the use of preferred stock. The current
corporate tax rate is 40%. (6 points)
Preferred Dividend
stock
Price
Flotation costs
Before tax
Cost of
preferred
After tax cost
of preferred
A
$3
$97
$3
3.19
3.19
B
$4.75
$75.75
$2.50
6.48
6.48
C
$7
$59
$1.75
12.23
12.23
3. Complete the following table for costs of financing with the use of common equity. The current
corporate tax rate is 40%. (9 points)
Stock
Dividend
Price
Growth
Flotation
rate of
costs
dividends
Before tax
Cost of
retained
earnings
Before tax
cost of
new
common
stock
After tax
cost of
new
common
stock
A
$1.75
$60
4%
$2
7.03
7.14
7.14
B
$2.95
$80
6%
$1.75
9.91
9.96
9.96
C
$3.85
$25
3.75%
$1
19.73
20.39
20.39
4. Using the securities above calculate the WACC for the following companies.
a. Company A finances its cash needs with 30% debt, 40% preferred stock, and 30% equity.
Content Coordinator: Dr. Lawrence Byerly
BUA321 CH09 Cost of Capital
i. WACC with RE
5.12%
ii. WACC with new common stock
5.15%
b. Company B finances its cash needs with 60% debt, 10% preferred stock, and 30% equity.
i. WACC with RE 5.14%
ii. WACC with new common stock 5.16
c. Company C finances its cash needs with 20% debt, 5% preferred stock, and 75% equity.
i. WACC with RE 16.29%
ii. WACC with new common stock 16.79%
5. Complete the following comprehensive cost of capital problem.
a. 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 flotation costs for debt average around $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%.
b. 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.
c. 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 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
d. What is the after-tax cost of debt? 4.22%
e. What is the after-tax cost of preferred? 6.33%
f.
What is the cost of retained earnings? 9.31%
g. What is the cost of new common equity? 9.40%
h. What is the capital structure of the financing? (what are the proportions?)
33.45% Debt
11.66 preferred
54.89% Equity
i.
What is the break point of debt? $597,948,718
j.
What is the breakpoint of equity? $910,937,500
k. Calculate the WMCC at the breakpoints:
7.26 /
7.93
Content Coordinator: Dr. Lawrence Byerly
/ 7.98