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0 1
-1,000 +1,100
5
Required Rates on Projects
An important part of capital budgeting is setting the
required rate for the individual project
Example: Consider the following project
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-1,000 +1,100
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-1,000 +1,100
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-1,000 +1,100
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-1,000 +1,100
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-1,000 +1,100
To find WACC
where:
It = Dollar Interest Payment
Po = Market Price of Debt
M = Maturity Value of Debt
15
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
16
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
It
P0 = (1 k ) n +
$M
(1+kd)n
t 1 d
17
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
n
It
P0 = (1 k ) n +
$M
(1+kd)n
t 1 d
12
$90
(1 k
$1,000
938.55 = 12
+
t 1 d ) (1+kd)10
18
Computing Cost of Each Source
1. Compute Cost of Debt
Example
Investors are willing to pay $985 for a bond that pays
$90 a year for 10 years. Fees for issuing the bonds
bring the net price (NP0) down to $938.55. What is the
before tax cost of debt?
From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)
23
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Cost to raise a dollar of preferred stock.
From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)
From Chapter 8:
Dividend (D)
Required rate kps =
Market Price (P0)
kps = $5.00
$42.00
27
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
kps = $5.00
= 11.90%
$42.00
28
Computing Cost of Each Source
2. Compute Cost Preferred Stock
Example
Your company can issue preferred stock for a price of
$45, but it only receives $42 after floatation costs. The
preferred stock pays a $5 dividend.
kps = $5.00
= 11.90%
$42.00
D1
kcs = + g
P0
36
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
D1
kcs = + g
P0
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
37
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Dividend Growth Model
Assume constant growth in dividends (Chap. 8)
Cost of internal equity--dividend growth model
D1
kcs = + g
P0
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
D1
kcs = + g
P0
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
D1
kcs = + g
P0
Example
The market price of a share of common stock is $60. The
dividend just paid is $3, and the expected growth rate is 10%.
kcs = 10% + 5%
49
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of Internal Common Equity
Risk Premium Approach
Adds a risk premium to the bondholder’s required rate of
return.
Cost of internal equity--Risk Premium
Where:
kcs = kd + RPc RPc = Common stock
Example risk premium
If the risk premium is 5% and kd is 10%
D1
kcs = + g
NP0
53
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
D1
knc = + g
NP0
54
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
55
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
Floatation
Costs
56
Computing Cost of Each Source
3. Compute Cost of Common Equity
Cost of New Common Stock
Cost of new common stock
D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
D1
knc = + g
NP0
Example
Using the above example. Common stock price is currently $60.
If additional shares are issued floatation costs will be 12%. D0 =
$3.00 and estimated growth is 10%.
NP0 = $60.00 – (.12x 60) = $52.80
Bonds kd = 10%
Preferred Stock kps = 11.9%
Common Stock
Retained Earnings kcs = 15%
New Shares knc = 16.25%
knc
72
Computing WACC - using New Common Shares
Balance Sheet
Assets Liabilities
Current Assets $5,000 Current Liabilities $2,000
Plant & Equipment 7,000 Bonds (10%) 4,000
Total Assets $12,000 Preferred Stock (11.9%) 1,000
Common Stock(16.25%)5,000
Tax Rate = 40% Total Liabilities and
Owners Equity $12,000
12%
11.09%
11%
Cost of Capital
using internal
10% common stock
9%
12%
11.09%
11%
10%
Break-Point for
9% common equity
12% 11.72%
11.09%
11%
Cost of Capital
using internal
10% common stock
9%
12% 11.72%
11.09%
11%
10%
9%
12%
11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%
12%
11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%
12%
Accept Projects #1 & #2
11% Project 1
IRR = 12.4%
Project 2
10% IRR = 12.1% Project 3
IRR = 11.5%
9%