Submitted by: Submitted by kstreetke
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Category: Business and Industry
Date Submitted: 09/25/2011 01:39 PM
Week 7: Cost of Capital
Very rough approximation procedure; at least 2 decimal places
SOURCES OF CAPITAL
1.) Barrowed money: Long-term borrowing
a. Bonds-Debt
2.) Preferred stock: Constant dividend
3.) Common Stock
b. Retained Earnings (fairly common)
c. New stock (fairly rare)
COST OF DEBT
-Taxes bias business decisions
-Tax rate = 40%
(1-T) => 60% of coupon rate payout [T= tax rate]
-Want cost expressed as a %
-Need to calculate YTM (Yield to Maturity)
COST OF DEBT = YTM (1-T)
COST OF PREFFERED STOCK
-Want it as a percent %
=DIVprefPVpref DIVpref = Dividend on preferred stock
DIVpref = Price we receive when preferred is issued
COST OF COMMON STOCK (3 Models)
1.) Gordon Model –Constant growth in dividends
k=DIV1PVo+ g
DIV1= DIV0(1+g)
2.) Security Market Line (SML)
k=kRF+ β(km-kRF)
3.) When all else fails
K = YTM +4%
4.) 3-Variable model – determines stockholders req’d rate of return
a. k= kRF+ γ1+γ2
i. k = risk free rate of return
ii. Gamma1-Business Risk. Relatively small for commercial bank, large for investment banks
iii. Gamma2-Financial Risk. Commercial, barrow less money; investment, borrow more money
1. Commercial have moderate financial risk, investment don’t have constraints on this factor
Weighted Average Cost of Capital (WACC)
Sources of Capital | Market Values | Weights | | Component Costs | | Weighted Cost |
Debts/Bonds | D | | X | | = | |
Preferred Stock | P | | X | | = | |
Common Stock | C | | X | | = | |
Total | | | | | | WACC |
Week 8: Business/Financial Risk
*What is business risk?: Explain.
- Variability of EBIT/ earning power of assets. Variability of EBIT can be affected by cyclical variations in demand, selling price, cost of input, and operating leverage.
Variability in EBIT
Earnings Before Interest and Taxes
Earning power of our...