Financial Management: Weighted Avg. Cost of Capital & Optimal Capital Structure Flashcards
WACC=
(Cost of Equity X Equity Capital Structure Percentage)+ (Weighted Avg. Cost of debt X Percentage debt in capital structure)
YTM
Effective Annual Interest Payment/ Debt Cash Available
Long-term elements
Long-term debt, preferred stock, common stock and retained earnings
Short-term elements
Interest-bearing debt, other forms of current liabilities A/P & Accruals
3 common methods of computing Costs of retained earnings
a) CAPM
b) Discounted Cash Flow
c) Bond yield plus risk premium
After tax cost of debt Or Net cost of Debt
YTM X(1-T)
Pretax ncost of debt Weighted Average interest Rate
Effective annual interest payments/ Debt Cash available
Par X C Outflow/ Net Inflow
After- Tax cost of debt
Pretax cost of debt X (1- Tax rate)
Cost of Preferred Cost > Cost Debt
- Dividends are not tax deductible
- PS assume more risk, bc they are paid last
Cost of Preferred stock formula
Preferred stock dividends/ Net proceeds of pref. stocks
=Par x%/ Net Inflow
Ex: Dividend paid ($20 par value × 9% dividend) $ 1.80
Net proceeds ($40 selling price − $5 floatation) ÷ 35.00
Cost of preferred shares 5.1%
CAPM
Beta> 1 riskier
Beta
CAPM Formula
Risk-free rate+ Risk Premium
Risk- free rate + (Beta X Market Risk Premium)
Risk free rate + (BetaX(Market Return - Risk free return)
Discounted Cash Flow Formula
-Cost of Retained Earnings
D/P +G
P= Current Market Price
D= Dividend per share expected at the end of the year
G= The constant rate of growth in dividends
Bond yield plus risk premium
“Pre-tax”
Pretax cost of long-term debt ( you can use YTM)+ Market risk premium
Market risk premium = reward for buying riskier CE
The over all cost of capital is the WACC
Rate of return on assets that covers the costs associated with the funds employed
The benefits of debt financing over equity financing are likely to be highest
High marginal tax rates and few noninterest tax benefits.
Weighted-average cost of capital
rate is most commonly compared to the internal rate of return to evaluate whether to make an investment
If a firm has an increase in the corportae income tax rate. What will that cause them to do?
It will cause the firm to increase the debt in its financial structure
The cost of debt most frequently is measured as:
Actual interest rate minus tax savings
What is a company’s objective when it comes to WACC?
To minimize the WACC
Which one of a firm’s sources of new capital usually has the lowest after tax cost
Bonds
The three elements needed to estimate the cost of equity capital are:
Current dividends per share (D)
Expected growth rate in dividends (G) and Current market price per share of common stock (P)
Are Dividends tax deductible?
No, Dividends are NOT tax deductible
