chapter 6-cost of capital.pptVIP

CHAPTER 6The Cost of Capital Sources of capital Component costs WACC Adjusting for flotation costs Adjusting for risk What sources of long-term capital do firms use? Component cost of debt The cost of debt, kd, is the interest rate on new borrowing. (marginal cost of debt capital vs. embedded cost of debt) The cost of debt is observable: a. Yield on currently outstanding debt. b. Yields on newly-issued similarly-rated bonds The historic debt cost is irrelevant -- why? EXAMPLE: A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (kd)? kd = 5.0% x 2 = 10% INSTEAD OF 12% Component cost of debt Interest is tax deductible, so A-T kd = B-T kd (1-T) = 10% (1 - 0.40) = 6% Component cost of preferred stock kp is the marginal cost of preferred stock. The rate of return investors require on the firm’s preferred stock. Preferred stock is a perpetuity, so the cost is kp = Dp / Pp Example: We sold an $8 preferred issue 10 years ago. It sells for $120/share today. The dividend yield today is $8.00/120 = 6.67%, so this is what we use as the cost of preferred stock. Component cost of preferred stock Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use kp. Is preferred stock more or less risky to investors than debt? More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm. Component cost of equity Capital from issuing new stocks- ke The rate of return investors require on the firm’s common equity using new equity is ke Capital from using retained earnings- ks ks is the marginal cost of common equity using retained earnings Why is there a cost for retained earnings? Earnings can be reinvested or paid out as dividends. Investors could buy other securities, earn a return. If earnings are retained, there is an opportunit