# Finc Study Guid

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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

-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 |