Financial Management Case

Topics: Weighted average cost of capital, Corporate finance, Investment Pages: 17 (3727 words) Published: October 9, 2013
Chapter 10
The Cost of Capital

Learning Objectives

After reading this chapter, students should be able to:
Explain what is meant by a firm’s weighted average cost of capital. Define and calculate the component costs of debt and preferred stock. Explain why the cost of debt is tax adjusted and the cost of preferred is not. Explain why retained earnings are not free and use three approaches to estimate the component cost of retained earnings. Briefly explain the two alternative approaches that can be used to account for flotation costs. Briefly explain why the cost of new common equity is higher than the cost of retained earnings, calculate the cost of new common equity, and calculate the retained earnings breakpoint—which is the point where new common equity would have to be issued. Calculate the firm’s composite, or weighted average, cost of capital. Identify some of the factors that affect the WACC—dividing them into factors the firm cannot control and those they can. Briefly explain how firms should evaluate projects with different risks, and the problems encountered when divisions within the same firm all use the firm’s composite WACC when considering capital budgeting projects. List some problems with cost of capital estimates.

Lecture Suggestions

Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the weighted average cost of capital (WACC), to develop a corporate cost of capital for use in capital budgeting. We begin by describing the logic of the WACC, and why it should be used in capital budgeting. We next explain how to estimate the cost of each component of capital, and how to put the components together to determine the WACC. We go on to discuss factors that affect the WACC and how to adjust the cost of capital for risk. We conclude the chapter with a discussion on some problems with cost of capital estimates. What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case solution for Chapter 10, which appears at the end of this chapter solution. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

Answers to End-Of-Chapter Questions

10-1Probable Effect on
rd(1 – T)rsWACC

a.The corporate tax rate is lowered.+0+

b.The Federal Reserve tightens credit.+++

c.The firm uses more debt; that is, it increases
its debt/assets ratio.++0

d.The dividend payout ratio is increased.000

e.The firm doubles the amount of capital it raises
during the year.0 or +0 or +0 or +

f.The firm expands into a risky new area.+++

g.The firm merges with another firm whose earnings
are counter-cyclical both to those of the first firm and
to the stock market.

h.The stock market falls drastically, and the firm’s stock falls along with the rest.0++

i.Investors become more risk averse.+++

j.The firm is an electric utility with a large investment in nuclear plants. Several states propose a ban on
nuclear power generation.+++

10-2An increase in the risk-free rate will increase the cost of debt. Remember from Chapter 6, r = rRF + DRP + LP + MRP. Thus, if rRF increases so does r (the cost of debt). Similarly, if the risk-free rate increases so does the cost of equity. From the CAPM equation, rs = rRF + (rM – rRF)b. Consequently, if rRF increases rs will increase too.

10-3Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt,...
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