2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.The Cost of CapitalSources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for RiskChapter 1010-1 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.What sources of capital do firms use?10-2 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Calculating the Weighted Average Cost of CapitalWACC = wdrd(1 T) + wprp + wcrs The ws refer to the firms capital structure weights. The rs refer to the cost of each component.10-3 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Should our analysis focus on before-tax or after- tax capital costs?Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.10-4 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.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. So, focus on todays marginal costs (for WACC).10-5 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.How are the weights determined?WACC = wdrd(1 T) + wprp + wcrs 10-6Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Overview of Coleman Technologies Inc.Firm calculating cost of capital for major expansion program.Tax rate = 40%.15-year, 12% coupon, semiannual payment noncallable bonds sell for $1,153.72. New bonds will be privately placed with no flotation cost.10%, $100 par value, quarterly dividend, perpetual preferred stock sells for $111.10.Common stock sells for $50. D0 = $4.19 and g = 5%.b = 1.2; rRF = 7%; RPM = 6%.Bond-Yield Risk Premium = 4%.Target capital structure: 30% debt, 10% preferred, 60% common equity. 9-7 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Review of Colemans Capital StructureNumber of shares not given in problem, so actual calculations cannot be done. Analysis is meant for illustration. Typically, book value capital structure will show a higher percentage of debt because a typical firms M/B ratio 1.9-8Book ValueMarket ValueTarget % Debt (includes notes payable)48%25%30%Preferred stock2510Common equity507060 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Component Cost of DebtWACC = wdrd(1 T) + wprp + wcrs 10-9rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Why tax-adjust; i.e., why rd(1 T)? 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (rd)?Remember, the bond pays a semiannual coupon, so rd = 5.0% x 2 = 10%.10-10INPUTSOUTPUTNI/YRPMTPVFV305-1153.72601000 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Component Cost of DebtInterest is tax deductible, so A-T rd= B-T rd(1 T)= 10%(1 0.40) = 6% Use nominal rate. Flotation costs are small, so ignore them.10-11 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.Component Cost of Preferred StockWACC = wdrd(1 T) + wprp + wcrs rp is the marginal cost of preferred stock, which is the return investors require on a firms preferred stock. Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp. Our calculation ignores possible flotation costs.10-12 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.What is the cost of preferred stock?The cost of preferred stock can be solved by using this formula:rp= Dp/Pp= $10/$111.10= 9%10-13 2013 Cengage L