Cost of Capital
 What is the appropriate discount rate?
 Capital Structure involves the use of:




 Optimal Capital Structure:
Debt Financing
 Cost of Debt:



 Ex. Archer’s Aquarium Equipment currently has bonds outstanding which
have 10 years remaining until maturity, offer a semi-annual coupon of $40
(8% coupon rate), and have a $1,000 par value. The bonds currently sell for
$975, and Wayne (the CFO) believes he can issue new bonds with a similar
yield to maturity. If AAE’s marginal tax rate is 40%, what is their after-tax
cost of debt?
Preferred Stock Financing
 Cost of Preferred Stock:



 Ex.Suppose Archer’s Aquarium Equipment has preferred stock outstanding
which offers an annual dividend of $8 per share, and is currently selling for
$65.50 per share. If additional shares of preferred stock are issued, the firm
must pay floatation costs of 6%. What is Archer’s cost of preferred stock?
Financing Via Retained Earnings
 Cost of Retained Earnings:



 The CAPM Approach
 Ex. Suppose the risk-free rate is 5%, the required rate of return on the market
portfolio is 13%, and the Beta coefficient of systematic (market) risk for
Archer’s Aquarium Equipment is 0.75. What is AAE’s Ks?
Retained Earnings, cont.
 The Bond-Yield plus Risk Premium Approach




 Ex. Archer’s Aquarium Equipment has bonds outstanding which yield
8.3740% If you believe the appropriate equity risk premium for AAE is 3%,
what is Archer’s required rate of return on retained earnings?
Retained Earnings, cont.
 Discounted Cash Flow (DCF) Approach



 Ex. Suppose Archer’s Aquarium Equipment recently paid a $3 dividend. In
addition, the firm’s dividends are expected to grow by 3% per year, and the
company’s stock is currently selling for $40 per share in the marketplace. What
is AAE’s cost of retained earnings?
 Which estimate of Ks is correct?
Retained Earnings Break Point
 Retained Earnings Break Point



 Ex. Suppose Archer’s Aquarium Equipment expects to generate $500,000,000
in net income next year. If the firm maintains its current payout ratio of 40%,
and current capital structure of 60% equity, 10% preferred stock, and 30% debt,
how large of a capital budget can AAE undertake without issuing additional
equity?
Weighted Average Cost of Capital (WACC)
 Given an optimal capital structure of 60% common equity,
30% debt, and 10% preferred stock, what is Archer’s
Aquarium Equipment’s weighted average cost of capital
(WACC) for capital budgets between zero and $50
million?