Unit 7

Types of Capital

Weighted Average Cost of Capital (WACC)

A weighted average of the component costs of debt, preferred stock, and common equity.

WACC= (% of debt)(After-tax cost of debt) + (% of preferred stock)(Cost of preferred stock) + (% of common equity)(Cost of common equity)

CAPM & CGM

This should be a review of the previous unit:

CAPM: rs=rRF + bi (RPM)

CGM: Po= D1/rs-g

Cost of Preferred Stock

Cost of preferred stock= rP = DP/PP

Example

Suppose you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm’s WACC?

AnswerWeight Cost

Debt 40% 4%

Preferred 10% 7.50%

Common 50% 11.5%

WACC= wdrd + wprp + wsrs

WACC= .40(4%) + .10(7.50%) + .50(11.50%) = ?

=8.10%

Example

Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company’s tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

Answer

First, you need to calculate the YTM on this bond. Input data into calculator:

N: 100; PV= -900.90; PMT: 20; FV= 1000; I/Yr =?Make sure that your cell is formatted to 2

decimal places.(Hint: This is the quarterly rate. You must

change to annual rate by multiplying by 4)……cont.

Answer

The YTM = 9% The YTM is the before tax cost of debt. Next,

you need to calculate the after-tax cost of debt:

YTM: 9%Tax rate: 40%After tax cost of debt: 9% * (1-.40)= 5.40%

Example Tapley Inc. recently hired you as a consultant to estimate

the company’s WACC. You have obtained the following information. (1) Tapley's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market price of $936.49. (2) The company’s tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and the stock’s beta is 1.5. (4) The target capital structure consists of 30% debt and 70% equity. Tapley uses the CAPM to estimate the cost of equity, and it does not expect to have to issue any new common stock. What is its WACC?

(Hint: you need to calculate the cost of debt and the cost of equity first)

Answer

First, you need to calculate the cost of debt by calculating the YTM on the bonds.

Input the following info into the calculator:N: 25; PV: -936.49; PMT: 75; FV: 1000; I/Yr: ?= 8.10%This is the before tax cost of debt. Calculate the

after-tax cost of debt:8.1% * (1-.40) = 4.86% …… cont.

Answer

Next, calculate the cost of equity capital using the CAPM:

6% + 1.5(5.0%) = 13.5%

Lastly, you solve for WACC:.30(4.86%) + .70(13.5%) =10.91%

Example

You were hired as a consultant to Locke Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7.0%, the cost of retained earnings is 11.50%, and the tax rate is 40%. The firm will not be issuing any new stock. What is the firm’s WACC?

Answer

First, calculate the after tax cost of debt:7.5 * (1-.40) = 4.50%

Next, chart it outWeights After tax

costs

Debt 40% 4.50%

Preferred 10% 7.0%

Common 50% 11.50%

WACC = .40(4.5%) + .10(7%) + .50(11.50%) = 8.25%

Example

To help finance a major expansion, Dimkoff Development Company sold a bond several years ago that now has 20 years to maturity. This bond has a 7% annual coupon, paid quarterly, and it now sells at a price of $1,103.58. The bond cannot be called and has a par value of $1,000. If Dimkoff’s tax rate is 40%, what component cost of debt should be used in the WACC calculation?

Answer

Solve for I/Yr as you did in previous examples: (This is paid quarterly so you adjust the numbers for

annual)PMT: 7% * 1,000 = $70 (adjust for quarterly) = 17.50Years: 20 ( *4 because it is quarterly) = 80PV: -1103.58FV: 1000I/Yr: ? (multiply by 4) = 6.1% (this is before tax cost of debt, calculate after-tax)= 6.1 * (1-.40) = 3.66%

Example

A company’s perpetual preferred stock currently trades at $80 per share and pays a $6.00 annual dividend per share. If the company were to sell a new preferred issue, it would incur a flotation cost of 4%. What would the cost of that capital be?

Answer

First, calculate the cost after floatation cost: (hint: set it up like the after-tax cost of debt)

$80 * (1-.04) = 76.80 Next, use the formula for the cost of preferred

stock: Cost of preferred stock= rP = DP/PP

6/76.80 = ?= 7.81%

Example

Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D1 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach?

Answer

You are using the CGM approach formula:Po = D1(r – g)Using the information given in the question, you

set up the formula as: r = (D1/Po) + g1.00/25 + .06 = ?= .10 (10%)