Guyton Finance 341 Exam 3
Interest - the cost of debt
Dividends - cost of stock
WACC - weighted average cost of capital
WdKd(1-t)+Wps(Kps)+Wce(Kce)
Why do you use after tax cost of debt to calculate WACC rather than before tax cost? -
Because the cost of debt is reduced by its tax deductibility
Which cost of debt is relevant? - The interest rate on new debt, because WACC is for
capital budgeting decisions...
What is often a reasonable estimate of new interest? - The Yield-To-Maturity (YTM)
because the YTM gives IRR from now til maturity.
Tax effects on Preferred Stocks - There is no tax adjustment for PS because the cost of
PS is dividends, and dividends aren't tax deductible
Cost of capital for PS - $div/$ per share = WACC
Growth of dividends - CS dividends often grow, PS usually do not
Flotation costs - costs that a financial institution will charge the company to get shares
out into the public (floating the shares)
3 approaches to find cost of common equity (Ks) - 1) Discounted Cash Flow (DCF) 2)
Capital Asset Pricing Model (CAPM) 3) Bond yield + Risk Premium
WACC vs. MCC - At every amount of capital raised, WACC represents the marginal
cost of that amount of capital
DCF Approach - Gordon Model
- (D1/P0)+G = Expected Ks
- DY+CGY
, CAPM Approach - Use SML
- Krf + (Km-Krf)(Beta) = Required Ks
Approach #3 - Bond Yield Plus Risk Premium Approach
- BY + RP = Ks
ST debt in capital structure - Short term debt (A/P, accruals) are not used in the capital
structure because they aren't investor supplied & don't accrue interest
2 factors that affect WACC beyond the firm's control - 1) Interest rates & 2) tax rates
3 factors that affect WACC under the firm's control - 1) capital structure 2) the
amount of dividends they pay (div. payout) 3) decision rules - accepting more or less risk
Interest rates increase... then... - cost of debt increases - more interest paid to
bondholders; interest rates for treasury bonds (Krf) go up, increasing Ks
What happens to stocks when interest rates increase? - investors become more
attracted to the bond market... so stock prices fall... ks rises (DCF method)
How to change hurdle rate for differing risks - high risk? add 2 percentage points to
WACC; low risk? subtract 2 percentage points from WACC
Retained Earnings Break point - (NI#1(1-d))/Wce*
Ke vs. Ks - Cost of newly issued common stock (Ke) will ALWAYS be higher than cost
of RE (Ks)
Cost of newly issued common stock - Ke = [D1 / (P0 (1-F))] + g
Why is issuing new CS risky? - because EPS = NI/Shares, and the only thing that is
guaranteed to go up is the # of shares.
How do you get the dividends of a preferred stock? - take the par value * the
percentage provided
What is the Bond Yield? - Kd as found by a new bond
What is the risk premium? - the extra amount required above t bonds (more risk more
reward)
Optimal capital budget - maximizes stock price; sum of the projects that we will accept
that do not surpass the RE break point
Interest - the cost of debt
Dividends - cost of stock
WACC - weighted average cost of capital
WdKd(1-t)+Wps(Kps)+Wce(Kce)
Why do you use after tax cost of debt to calculate WACC rather than before tax cost? -
Because the cost of debt is reduced by its tax deductibility
Which cost of debt is relevant? - The interest rate on new debt, because WACC is for
capital budgeting decisions...
What is often a reasonable estimate of new interest? - The Yield-To-Maturity (YTM)
because the YTM gives IRR from now til maturity.
Tax effects on Preferred Stocks - There is no tax adjustment for PS because the cost of
PS is dividends, and dividends aren't tax deductible
Cost of capital for PS - $div/$ per share = WACC
Growth of dividends - CS dividends often grow, PS usually do not
Flotation costs - costs that a financial institution will charge the company to get shares
out into the public (floating the shares)
3 approaches to find cost of common equity (Ks) - 1) Discounted Cash Flow (DCF) 2)
Capital Asset Pricing Model (CAPM) 3) Bond yield + Risk Premium
WACC vs. MCC - At every amount of capital raised, WACC represents the marginal
cost of that amount of capital
DCF Approach - Gordon Model
- (D1/P0)+G = Expected Ks
- DY+CGY
, CAPM Approach - Use SML
- Krf + (Km-Krf)(Beta) = Required Ks
Approach #3 - Bond Yield Plus Risk Premium Approach
- BY + RP = Ks
ST debt in capital structure - Short term debt (A/P, accruals) are not used in the capital
structure because they aren't investor supplied & don't accrue interest
2 factors that affect WACC beyond the firm's control - 1) Interest rates & 2) tax rates
3 factors that affect WACC under the firm's control - 1) capital structure 2) the
amount of dividends they pay (div. payout) 3) decision rules - accepting more or less risk
Interest rates increase... then... - cost of debt increases - more interest paid to
bondholders; interest rates for treasury bonds (Krf) go up, increasing Ks
What happens to stocks when interest rates increase? - investors become more
attracted to the bond market... so stock prices fall... ks rises (DCF method)
How to change hurdle rate for differing risks - high risk? add 2 percentage points to
WACC; low risk? subtract 2 percentage points from WACC
Retained Earnings Break point - (NI#1(1-d))/Wce*
Ke vs. Ks - Cost of newly issued common stock (Ke) will ALWAYS be higher than cost
of RE (Ks)
Cost of newly issued common stock - Ke = [D1 / (P0 (1-F))] + g
Why is issuing new CS risky? - because EPS = NI/Shares, and the only thing that is
guaranteed to go up is the # of shares.
How do you get the dividends of a preferred stock? - take the par value * the
percentage provided
What is the Bond Yield? - Kd as found by a new bond
What is the risk premium? - the extra amount required above t bonds (more risk more
reward)
Optimal capital budget - maximizes stock price; sum of the projects that we will accept
that do not surpass the RE break point
