Professional Documents
Culture Documents
Cost of Capital
Cost of Capital
Net Proceeds
Cost of debt
Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying
annual interest at a 12% coupon rate. As a result of current interest rates, the
bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred
in this process. The firm is in the 40% tax bracket.
a. Find the net proceeds from sale of the bond, Nd.
b. Show the cash flows from the firm’s point of view over the maturity of the
bond.
c. Use the approximation formula to estimate the before-tax and after-tax costs of
Debt.
rS = (D1/P0) + g
rE = rF + b(rM - rF).
rs = D1/P0 + g
rs = rF + b(rM - rF).
rn = = D1/Nn - g
To estimate the weight for equity, simply divide the total book
value of equity by the book value of total assets.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-29
The Weighted Average Cost of Capital
For example, assume the market value of the firm’s debt is $40
million, the market value of the firm’s preferred stock is $10
million, and the market value of the firm’s equity is $50 million.
= 11.13%
BPj = AFj/wj
where:
BPj = breaking point form financing source j
AFj = amount of funds available at a given cost
wj = target capital structure weight for source j
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-35
The Marginal Cost
& Investment Decisions (cont.)
Assume that in the example we have been using that the firm has
$2 million of retained earnings available. When it is exhausted,
the firm must issue new (more expensive) equity. Furthermore,
the company believes it can raise $1 million of cheap debt after
which it will cost 7% (after-tax) to raise additional debt.
Given this information, the firm can determine its break points as
follows:
This implies that the firm can fund up to $4 million of new investment
before it is forced to issue new equity and $2.5 million of new investment
before it is forced to raise more expensive debt.
Given this information, we may calculate the WMCC as follows:
11.76% WMCC
11.75%
11.66%
11.50%
11.25%
11.13%
13.0% A WMCC
12.0% B
11.66%
This indicates
11.5%
C that the firm can
accept only
Projects A & B.
11.13% D
11.0%
Source of Capital Book Value ($) Market Value ($) After-tax cost
Long-term debt 4,000,000 3,840,000 6%
Preferred Stock 40,000 60,000` 13%
Common Stock 1,060,000 3,000,000 17%
Totals 5,100,000 6,900,000
a. Calculate the weighted average cost of capital using book value weights.
b. Calculate the weighted average cost of capital using market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.