Finc Study Guid

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...