chapter 10 - the cost of capital

Question 1

Why do we care about the weighted average
cost of capital?

Answer 1

Knowing the WACC is necessary for making corporate investment decisions (build a new factory?)

Two sides of an investment decision:
How much money will this project make?
How much does it cost for the firm to get the funds for this investment?

WACC calculates the cost
This is why we care: it’s necessary for corporate investment decisions

Question 2

What are the three main sources of capital for
the firm?

Answer 2

debt, preferred stock and common equity

Question 3

What are the two components of
common equity? Two components of debt?

Answer 3

common equity: retained earnings and new common stock
debt: notes-payable (short term) and long term debt

Question 4

How do we calculate WACC? (Including
finding the cost of debt, preferred stock,
and equity, given target weights)

Answer 4

WACC = wdrd(1 – T) + wprp + wcrs

The w’s refer to the firm’s weights.
Wd = Weight of debt
Wp = Weight of preferred stock
Wc = Weight of common stock
The r’s refer to the cost of each component.
Rd = cost of debt
Rp = cost of preferred stock
Rs = cost of common stock

(1) Determine optimal weights wd, wp, wc
(2) Find the cost of debt rd
(3) Find the cost of preferred stock rp
(4) Find the cost of common stock rs
(5) Plug numbers into the formula and find WACC!
Target weights are:
40% debt; 10% preferred; 50% equity
Costs of each component:
Debt is 8%, preferred stock is 10%, common equity is 12%
WACC: (25% tax rate)
= (.4)(.08)(1-.25) + (.10)(.10) + (.5)(.12)
= .094 or 9.4%

Question 5

Do we care about after-tax or pre-tax analysis?
Why?

Answer 5

Stockholders care about after-tax CFs. Shareholders receive dividends after taxes are paid.
Therefore, we should focus on after-tax capital costs; i.e., use after-tax costs of capital in WACC.

Only one source of capital - rd - needs adjustment, because interest is tax deductible.

Question 6

What are the three ways/methods of
determining a company’s target weights?

Answer 6

There are three ways that optimal weights are determined:
1. Management sets target weights
2. Use book value weights
3. Use market value weights

Question 7

What are the three ways to determine the cost
of common equity? Know how to calculate them.

Answer 7

• CAPM: rs = rRF + (rM – rRF)b
• DCF: rs = (D1/[Po*(1-F)]) + g
  G = growth rate of dividends
  P0 = stock price this year
  D1 = Dividends next year
  1-F: flotation cost
• Bond-Yield-Plus-Risk-Premium:
  rs = rd + RP

Equity-Bond Risk premium???

Question 8

Why is there a cost for retained earnings?

Answer 8

• Earnings can be reinvested or paid out as dividends.
• Investors can use dividends to buy other securities and earn a higher return
• If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk).

Investors could buy similar stocks and earn rs.
Firm could repurchase its own stock and earn rs.
So a firm shouldn’t keep cash on its balance sheet if it isn’t needed. Pay out excess cash as dividends.

Question 9

What factors influence a company’s composite
WACC? Know has each impacts the company.

Answer 9

Factors the firm cannot control:
Market conditions such as interest rates and tax rates. The Federal Reserve can increase or lower WACC.
Factors the firm can control:
Firm’s capital structure: combo of debt, preferred, and common equity
Firm’s dividend policy.
The firm’s investm

Question 10

IMPORTANT - MULTIPLE QUESTIONS ON EXAM: How can firms change their capital structure?

Answer 10

How companies can increase the weight of equity (or decrease the weight of debt): (equity + debt = total capital)
- Issue stock (SEO/IPO)
- Retain more earnings (pay out fewer dividends)
- Call bonds, buy back debt decrease in debt, increases equity
- $100m debt, 100m stock; 50m debt, 100m stock
Reduces debt by 50m, 100m stock; (⅓ debt, ⅔ equity)

How companies can decrease the weight of equity or increase the weight of debt:
- Buyback stock with retained earnings
- Pay out more earnings as dividends (reduces equity)
- Issue more bonds increase debt, decrease equity

Question 11

Should the company use the composite WACC
as the hurdle rate for each project? Why not?

Answer 11

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.

Question 12

What are flotation costs and why do they make
retained earnings cheaper than issuing new
common stock?

Answer 12

what are they?
- Flotation costs are costs associated with the process of issuing securities, such as common or preferred stock.
Fee paid to investment banks/underwriters

why do they make retaine dearnings cheaper than issuing new common stock?
- no. Retained earnings DO NOT incur flotation costs! So retained earnings is cheaper than issuing new common stock.
Re, cost of new equity > retained earnings b/c flotation costs!
So a company prefers using retained earnings rather than issuing new common stock in most cases

Question 13

Cost of equity will always be greater than
the cost of debt. true or false?

Answer 13

true

Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt.

Question 14

“Debt is cheap, equity is expensive” true or false

Answer 14

Equity financing is generally more expensive than debt financing. Why is debt cheaper than equity? Simply put, because equity carries a higher risk for investors

Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders’ expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

Question 15

More debt causes/what causes debt:

Answer 15

• Cost of equity goes up
• Cost of debt goes up
• WACC may go up or down

Question 16

Management can fund new investments by:

Answer 16

• Issuing equity
• Reducing dividend payouts (retain more earnings)
• Issue debt

Question 17

Management often doesn’t want to issue new
equity because it’s expensive, so instead:

Answer 17

• 1. Retain more earnings
• 2. Use more debt

Question 18

capital structure concept

Answer 18

Most firms use too little debt according to capital structure models. In this case, using additional debt will lower WACC

Debt is cheaper than common equity, so using more debt reduces WACC.

Caveat: Eventually, as you issue too much debt, the cost of equity and debt increases too much (bankruptcy risk) and WACC goes up!

Three possible weights to use above. Different methods will yield different WACC. –> debt, preferred stock, common equity

Target is the default measure to use

Which yield the highest WACC? Lowest?

Question 19

capital structure concept

Answer 19

Most firms use too little debt according to capital structure models. In this case, using additional debt will lower WACC

Debt is cheaper than common equity, so using more debt reduces WACC.

Caveat: Eventually, as you issue too much debt, the cost of equity and debt increases too much (bankruptcy risk) and WACC goes up!

Three possible weights to use above. Different methods will yield different WACC. –> debt, preferred stock, common equity

Target is the default measure to use

Which yield the highest WACC? Lowest?

Question 20

coleman’s capital structure

Answer 20

Market Value: Too little debt, too much equity
Cost of capital will be TOO high relative to the target cost

How can firm adjust?
- Issue more debt
- Repurchase shares (Decreases equity)
- Change dividend policy.

Question 21

Cost of components from most to least expensive:

Answer 21

• 1. New common equity (Re)
• 2. Retained earnings (Rs)
• 3. WACC
• 4. Preferred Stock (Rp)
• 5. Debt (Rd)

Question 22

There are 3 ways that management can change
the firm’s capital structure:

Answer 22

• 1. Equity/Common Stock:
      Issue new stock (increase equity; decrease equity)
      Repurchase/buyback stock (decrease equity;
     increase debt)
• 2. Debt:
      Issue debt (increase debt, decrease equity)
      Buyback/call debt (decrease debt, increase equity)
• 3. Dividends:
      Increase dividends (decrease equity, increase debt)
      Decrease dividends (increase equity, decrease debt)

Question 23

If we are BELOW percentage of optimal
amount of debt:

Answer 23

• 1. issue more debt (bonds)
• 2. Reduce equity
      Buyback shares
      Pay out dividends

Question 24

If we are ABOVE the percentage of optimal
amount of debt

Answer 24

• 1. Retire debt, decrease, buying back bonds,
     paying down debt
• 2. Increase equity:
      Issue new shares
      Reduce dividend payments/reduce buybacks