Liabilities & Equity Assets Debt Preferred Stock $ Bank 14% Common Stock 5% R.O.I. (cost of $)

Total Liabilities = Total Assets & Equity

Chapter 10 Cost of Capital

Chapter 10 Cost of Capital

Capital Structure

$ %

Debt $50 50%

Preferred 30 30%

Common 20 20%

Total $100 100%

Chapter 10 Cost of Capital

Cost of $

$ % k (given)

Debt $50 50% 10%

Preferred 30 30% 12%

Common 20 20% 14%

Total $100 100%

Chapter 10 Cost of Capital

Wt’d Avg Cost

Cost of $ of Capital

$ % k (given) tax 40%

Debt $50 50% 10% 0.5(10%)x(1-tax)=3%

Preferred 30 30% 12% 0.3(12%) =3.6%

Common 20 20% 14% 0.2(14%) =2.8%

Total $100 100% WACC =9.4%

(1) Cost of Old Debt (Kd)

Kd

= interest

= 10

= 10%

principal 100(2) Cost of Old Preferred Stock (Kps)

Kps

= Dividend to P.S.

= 12

= 12% P.S. price 100(3) Cost of Old Common Stock (Ks)

Ks

= D1

+ g = 2

+ 4% = 14%

P0 20

Ks = Risk Free Rate + Risk Premium

For the following example...

FLOTATION COST

f = Flotation Cost = 5%

(1) Cost of New Debt (Kd)

Kd

= interest

= 10

= 10.53%

principal(1-f) 100(1-.05)

(2) Cost of New Preferred Stock (Kps)

Ks

=Dividend to P.S.

= 12

= 12.63%

P.S. price (1-f) 100(1-.05)

(3) Cost of New Common Stock (Ks)

Ks

= D1 + g =

2 + 4% = 14.53%

P0 (1-f) 20(1-.05)

Ks = Risk Free Rate + Risk Premium

Chapter 10 Cost of Capital

Wt’d Ave. Cost Cost of $ of Capital

$ % k (given) & tax @ 40%Debt $50 50% 10.53% 0.5(.1053)x(1-tax)=3.16%Pref. 30 30% 12.63% 0.3(.1263) =3.79%Comm. 20 20% 14.53% 0.2(.1453) =2.91%Total $100 100% WACC =9.86% Marginal Cost of Capital (MCC) = 9.86%

Percent

a = 16%

b = 14%

c = 12%

d = 8%IOS

WACC = 9.40%

WACC = 9.50%

WACC = 9.86%MCC

New capital raised & invested duringthe year

Optimal Capital Budget

WACC=weighted cost of capitalMCC=marginal cost of capitalIOS=investment opportunity schedule