20.3: Estimating the Non-Equity Component Costs

Question 1

What are issuing or flotation costs?

Answer 1

Issuing or flotation costs are expenses incurred by a firm when it issues new securities, including fees paid to investment dealers and discounts to entice investors.

Question 2

What is the Marginal Cost of Capital (MCC)?

Answer 2

The Marginal Cost of Capital (MCC) is the weighted average cost of the next dollar of financing to be raised, often exceeding WACC due to additional costs.

Question 3

How does the Marginal Cost of Capital (MCC) differ from the Weighted Average Cost of Capital (WACC)?

Answer 3

MCC represents the cost of raising the next dollar of financing, often higher than WACC due to flotation costs, while WACC reflects the average cost of all financing sources.

Question 4

What are some typical flotation costs for different financing methods?

Answer 4

• Commercial Paper: 0.125%
• Medium-Term Notes: 1%
• Long-Term Debt: 2%
• Equity (Large): 5%
• Equity (Small): 5% to 10%
• Equity (Private): 10% and up

Question 5

Why do flotation costs cause the Marginal Cost of Capital (MCC) to exceed the Weighted Average Cost of Capital (WACC)?

Answer 5

Flotation costs increase MCC as firms incur additional expenses for issuing new securities, making the next dollar of financing more expensive than the average cost reflected in WACC.

Question 6

How do issuing costs create a “financing wedge”?

Answer 6

(Additional) How do issuing costs create a “financing wedge”?
A: Issuing costs create a financing wedge by reducing the net proceeds received by the firm from new issues, making it necessary for the firm to earn enough to cover both equity costs and issue expenses.

Question 7

What are flotation costs, and why do they increase the cost of new securities?

Answer 7

Flotation costs are costs incurred by a firm when it issues new securities, including fees paid to investment dealers and discounts provided to investors.

These costs increase the cost of new securities because they lower the net proceeds received by the firm, making it more expensive to raise capital.

Question 8

Define the marginal cost of capital (MCC) and its relationship with the weighted average cost of capital (WACC).

Answer 8

The marginal cost of capital (MCC) is the weighted average cost of the next dollar of financing to be raised.

MCC often exceeds WACC due to additional costs associated with raising new capital, such as flotation costs, which make raising new money more expensive.

Question 9

Explain why MCC can exceed WACC and the implications for a firm’s cost of capital.

Answer 9

MCC can exceed WACC because issuing new securities incurs flotation costs, which increase the overall cost of raising new funds.

When MCC exceeds WACC, the firm must carefully consider whether raising new capital is justified, as it will increase the overall cost of capital.

Question 10

How can a firm estimate the cost of debt using flotation costs?

Answer 10

A firm can estimate the cost of debt by adjusting the bond valuation equation to account for flotation costs, which are immediately tax-deductible.

The adjusted formula allows for calculating the after-tax cost of debt, considering the net proceeds from the bond issuance.

Question 11

Explain the steps in determining a firm’s before- and after-tax cost of debt using flotation costs.

Answer 11

1. Calculate the net proceeds (NP) by subtracting flotation costs from par value.
   
   2. Adjust the bond’s interest payment for tax savings.
   3. Use the adjusted formula to find the cost of debt (ki).
   4. Calculate the after-tax cost by considering the tax shield on interest.

Question 12

Describe how to use a financial calculator to find the cost of debt after flotation costs.

Answer 12

To find the cost of debt:
1. Adjust the payment for tax savings: PMT = interest × (1 - tax rate).
2. Enter the adjusted payment, net proceeds, par value, and term into the calculator.
3. Solve for the interest rate (I/Y) to find the after-tax cost of debt.

Question 13

Why is the weighted average cost of capital (WACC) so important?

Answer 13

WACC represents the average rate of return required by all investors who have contributed capital to the firm.

It reflects the opportunity cost of investing in the firm and is crucial for evaluating investment projects and determining the firm’s value.

Question 14

What are the steps involved in estimating a firm’s WACC?

Answer 14

1. Estimate market values for the firm’s sources of capital.
   
   2. Estimate the current required rates of return for these capital sources.
   3. Weight the costs of all sources of capital, considering corporate tax benefits, to find the WACC.

Question 15

How can we estimate the market value of common equity, preferred equity, and long-term debt?

Answer 15

• Common equity: Multiply the market price per share by the number of shares outstanding.
  
  • Preferred equity: Use the preferred shares’ market price or value based on expected dividends.
  • Long-term debt: Use bond valuation models, adjusting for current market rates or book value.

Question 16

What is the significance of flotation costs in investment decisions?

Answer 16

Flotation costs can significantly impact the decision to raise new capital as they increase the cost of financing. Firms must weigh these costs against the potential returns from investment projects to determine if new capital is justified.

Question 17

What are the three major problem areas in finance related to valuation, cost of capital, and cash flows?

Answer 17

The three major problem areas are valuation, cost of capital, and determining cash flows.

These areas are interconnected and essential for financial decision-making in any firm.

Question 18

Define ‘Capital Structure’.

Answer 18

Capital Structure is how a firm finances its invested capital, which involves deciding what proportion of funding is through debt and what proportion is through equity.

Question 19

Explain the difference between financial structure and capital structure.

Answer 19

Financial structure includes all of a firm’s liabilities and equity, reflecting how it finances its total assets, while capital structure refers specifically to the proportion of debt and equity used to finance invested capital.

Question 20

What is the impact of issuing costs on a firm’s financing decisions?

Answer 20

Issuing costs create a financing wedge between the investor’s payment and the firm’s net proceeds, making new external financing more expensive than using retained earnings.

Question 21

How do changes in securities regulation affect issuing costs?

Answer 21

Changes in securities regulation can lower issuing costs for large firms due to compliance requirements being met, but small firms may face significant costs due to higher market and legal barriers.

Question 22

How can issuing costs affect a firm’s access to capital markets?

Answer 22

High issuing costs can limit a firm’s ability to access capital markets affordably, affecting its capital structure and investment strategy by making external financing more costly.

Question 23

Why are issuing costs considered a financing wedge?

Answer 23

Issuing costs create a financing wedge because they represent money lost between what investors pay and what the firm receives, increasing the firm’s cost of capital.

Question 24

How are issuing costs related to capital rationing?

Answer 24

Issuing costs can lead to capital rationing by restricting a firm’s ability to finance all desired investments, prioritizing projects with higher returns to cover these additional costs.

Question 25

Explain how flotation costs are tax-deductible.

Answer 25

Flotation costs for debt are tax-deductible, reducing the taxable income of the firm immediately, unlike the principal repayments, which are not tax-deductible.

Question 26

How do flotation costs affect the cost of capital sources for a firm?

Answer 26

Flotation costs increase the cost of capital for a firm by reducing the net proceeds received from issuing new securities, leading to a higher required return to cover these costs. This can make external financing more expensive compared to internal funds.

Question 27

Explain how to estimate the cost of debt for a firm.

Answer 27

The cost of debt is estimated by calculating the yield to maturity (YTM) on existing debt or the interest rate on new debt, adjusted for tax benefits, as interest is tax-deductible. This involves using the formula for the net proceeds (NP) and adjusting for flotation costs and taxes:

ki = I × (1 - T) × [(1 - (1 + ki)^-n) / ki] + [F / (1 + ki)^n]

where ki is the cost of debt,
I is the interest payment,
T is the tax rate,
n is the number of periods, and
F is the face value of the debt.

Question 28

Explain how to estimate the cost of preferred equity for a firm.

Answer 28

The cost of preferred equity is estimated by dividing the preferred dividend (Dp) by the net proceeds from issuing the preferred shares (NP), which considers flotation costs:

kp = Dp / NP

where kp is the cost of preferred equity, Dp is the preferred dividend, and NP is the net proceeds.