FINA 2201 Chapter Notes - Chapter 10: Discounted Cash Flow, Retained Earnings, Risk Premium

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periwinkledinosaur391

15 Mar 2016

School

Northeastern University

Department

Finance & Insurance

Course

FINA 2201

Professor

Mazur Jack

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10-1 an overview of the weighted average cost of capital (wacc) When calculating the wacc, our concern is with capital that must be provided by investors interest-bearing debt, preferred stock, and common equity target capital structure, which refers to how allied plans to raise capital to fund its future projects. After tax cost of debt=interest rate on new debt-tax savings cost of debt is the interest rate on new debt, not outstanding debt. For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate. Similarly, the cost of common equity is based on the rate of return that investors require on the company"s common stock. Note, though, that new common equity is raised in two ways: (1) by retaining some of the current year"s earnings and (2) by issuing new common stock.

Related Questions

The Cost of Capital: Weighted Average Cost of Capital

The firm's target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise funds for its future projects. The target proportions of debt, preferred stock, and common equity, along with the cost of these components, are used to calculate the firm's weighted average cost of capital (WACC). If the firm will not have to issue new common stock, then the cost of retained earnings is used in the firm's WACC calculation. However, if the firm will have to issue new common stock, the cost of new common stock should be used in the firm's WACC calculation.

Quantitative Problem: Barton Industries expects that its target capital structure for raising funds in the future for its capital budget will consist of 40% debt, 5% preferred stock, and 55% common equity. Note that the firm's marginal tax rate is 40%. Assume that the firm's cost of debt, rd, is 7.5%, the firm's cost of preferred stock, rp, is 7% and the firm's cost of equity is 11.5% for old equity, rs, and 11.87% for new equity, re. What is the firm's weighted average cost of capital (WACC1) if it uses retained earnings as its source of common equity? Round your answer to 3 decimal places. Do not round intermadiate calculations.
%

What is the firmâs weighted average cost of capital (WACC2) if it has to issue new common stock? Round your answer to 3 decimal places. Do not round intermadiate calculations.
%

raspberryyak84

Part I. Given the tax rate of 40% of this corporation, calculate its after-tax weighted average cost of capital (WACC) for Duke Corporation.

Table: the before-tax weighted average cost of capital (WACC) for Duke Corporation

Source of Capital	Weight (1)	Cost (2)	Weighted Cost (1) X (2)
Long-Term Debt	.4	5.6%	2.24%
Preferred Stock	.1	10.6%	1.06%
Common Stock Equity	.5	13%	6.5%
Totals	1		9.8%

Part II. Answer true, false or uncertain and explain briefly on the following statement. "the after-tax wacc cannot ever be higher than the before-tax wacc."

The calculation of WACC involves calculating the weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of financing in the firm's overall capital structure.

Re is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of capital (WACC) equation.

Reymond Co. has $1.1 million of debt, $1 million of preferred stock, and $2.1 million of common equity. What would be its weight on common equity?

a) 0.19

b) 0.24

c) 0.50

d) 0.22

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FINA 2201 Chapter Notes - Chapter 10: Discounted Cash Flow, Retained Earnings, Risk Premium

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