Chapter 10 Flashcards
What sources of capital do firms use?
- Capital
- Debt: Notes Payable, Long-term debt
- Preferred stock
- Common Equity: Retained Earnings, New Common Stock
Calculating the Weighted Average Cost of Capital
- WACC = wdrd(1 – T) + wprp + wcrs
- The w’s refer to the firm’s capital structure weights
- The r’s refer to the cost of each component
Should our analysis focus on before-tax or after-tax capital costs?
- Stockholders focus on after-tax CFs
- Therefore, we should focus on after-tax capital costs; i.e., use after-tax costs of capital in WACC
- Only rd needs adjustment, because interest is tax deductible
Should our analysis focus on historical (embedded) costs or new (marginal) costs?
- The cost of capital is used primarily to make decisions that involve raising new capital
- Focus on today’s marginal costs (for WACC)
Component Cost of Debt
- rd(1 – T)
- rd is the marginal cost of debt capital
- The yield to maturity on outstanding L-T debt is often used as a measure of rd
- Interest is tax deductible
Component Cost of Preferred Stock
- rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock
- Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp
- Our calculation ignores possible flotation costs
- rp = Dp/Pp
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
Why is the yield on preferred stock lower than debt?
- Preferred stock will often have a lower BT yield than the BT yield on debt
- Corporations own most preferred stock, so 70% of preferred dividends are excluded from corporate taxation
- The AT yield to an investor, and the AT cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock
Component Cost of Equity
- rs is the marginal cost of common equity using retained earnings
- The rate of return investors require on the firm’s common equity using new equity is re
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 opportunity cost (the return that stockholders could earn on alternative investments of equal risk):
1. Investors could buy similar stocks and earn rs
2. Firm could repurchase its own stock and earn rs
Three Ways to Determine the Cost of Common Equity, rs
- CAPM: rs = rRF + (rM – rRF)b
- DCF: rs = (D1/P0) + g
- Bond-Yield-Plus-Risk-Premium: rs = rd + RP
Can DCF methodology be applied if growth is not constant?
- Yes, nonconstant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years
- May be complicated to calculate
Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
- When a company issues new common stock they also have to pay flotation costs to the underwriter
- Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price
What factors influence a company’s composite WACC?
Factors the firm cannot control:
1. Market conditions such as interest rates and tax rates
Factors the firm can control:
- Firm’s capital structure
- Firm’s dividend policy
- The firm’s investment policy. Firms with riskier projects generally have a higher WACC
Should the company use the composite WACC as the hurdle rate for each of its projects?
- NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk
- Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk
