Session 9 - Weighted Average Cost of Capital, Chapter 9

All page numbers are references to Corporate Finance: A Focused Approach 4th edition by Ehrhardt and Brigham (South-Western, 2011)

Weighted Average Cost of Capital - This chapter applies Chapter 6 Risk and Return concepts to the Balance Sheet of Corporations.  The basic task is to calculate the return on a  portfolio, where the portfolio consists of the securities issued by a single company (i.e., their long term debt and equity).  This is a review chapter in that we apply techniques learned in Chapters 5, 6, and 7 in a new way.

Need to know – All of the general material to estimate Cost of Capital, including after-tax cost of debt, cost of preferred stock with floatation costs, and the three methods of calculating the cost of common equity.  Understand how to calculate all of the components of equation 9-10 on page 339.  You should be able to convert a book value balance sheet to a market value balance sheet.  You should be able to calculate the Weights in the equation using a market value balance sheet.  Pay particular attention to the Mistakes to Avoid on pages 367-368, as this topic is often the source of concept questions.

Do not need to know - Factors that affect the WACC (Section 9.11) are tested using Chapter 14 material rather than material from this chapter, how to estimate beta risk.  It is highly unlikely we will ask Final Exam questions where the firm needs to issue new common equity, thus calculating the Cost of Common Equity with adjustments for floatation costs should have a low priority.  I will also not ask about applying the Cost of Capital to privately owned firms (Section 9.14)

Questions and Problems that you should answer-Question 1, 2, and 3, Self-test 1,  and Problems 1-17.  Note that Problems 15-17 are good reviews for the final exam.

Calculator links: Most Calculator Types

While the videos refer to chapter 10, they cover the material and minicase (376-377) from Chapter 9.

1. Watch the Chapter Overview Video.  

2. Read pages 335-339.

3.  Watch the video, Costs of Debt and Preferred Stock.

6. Solve Problems 1-4 and 9.

7. Read pages 340-353.

 8. Watch the video, Cost of Common Equity.

 9. Solve Problems 5, 6, and 10-13.

10.  Read pages 353-355.

11. Watch the video, Weights and Final Calculation of the WACC. Note this video  contains a discussion of common errors made in calculating WACC.

12.  Solve Problem 7, 8, 15 and 16.

13.  Read the remainder of Chapter 9.

14.  Watch the video on WACC; Adjusting for Project Risk and Odds and Ends.

15. Solve the remaining suggested problems.

16. Here are audio solutions, courtesy of Dr. Ronald Best, to problems that are similar to those covered in this chapter;

a. Audio Solution to: Costly Corporation plans a new issue of bonds with a par value of $1,000, a maturity of 28 years, and an annual coupon rate of 16.0%. Flotation costs associated with a new debt issue would equal 9.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds of firms similar to Costly is 17.0%. The firm's marginal tax rate is 30%. What will the firm's true cost of debt be for this new bond issue?

b. Audio Solution to: Costly Corporation is also considering using a new preferred stock issue. The preferred would have a par value of $400 with an annual dividend equal to 18.0% of par. The company believes that the market value of the stock would be $968.00 per share with flotation costs of $68.00 per share. The firm's marginal tax rate is 40%. What would the firm's cost of preferred be for this new preferred stock issue?

c. Audio Solution to: Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $47.00 per share. The firm's dividend for next year is expected to be $3.40 with an annual growth rate of 5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 14.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of internal equity?

d. Audio Solution to: Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $31.00 per share. The firm's dividend for next year is expected to be $5.50 with an annual growth rate of 5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external equity?

e. Audio Solution to: Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $155 million?

f. Audio Solution to: Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $247 million?

g. Audio Solution to: Marginal Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $157 million?

h. Audio Solution to: Marginal Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $247 million?

i. Audio Solution to: Marginal Incorporated (MI) has determined that its before-tax cost of debt is 7% for the first $112 million in bonds it issues, and 8% for any bonds issued above $112 million. Its cost of preferred stock is 10%. Its cost of internal equity is 14%, and its cost of external equity is 17%. Currently, the firm's capital structure has $400 million of debt, $100 million of preferred stock, and $500 million of common equity. The firm's marginal tax rate is 30%. The firm is currently making projections for next period. Its managers have determined that the firm should have $59 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at each of the following total investment levels?

(A) Total investment level of $380 million? (B) Total investment level of $199 million? (C) Total investment level of $69 million?

j. Audio Solution to: Marginal Incorporated (MI) has determined that its after-tax cost of debt is 6% for the first $100 million in bonds it issues, and 8% for any bonds issued above $100 million. Its cost of preferred stock is 9%. Its cost of internal equity is 12%, and its cost of external equity is 14%. Currently, the firm's capital structure has $600 million of debt, $100 million of preferred stock, and $300 million of common equity. The firm's marginal tax rate is 30%. The firm is currently making projections for next period. Its managers have determined that the firm should have $75 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at each of the following total investment levels?

(A) Total investment level of $280 million? (B) Total investment level of $200 million? (C) Total investment level of $77 million?

17.  Be prepared for a 40-60 minute quiz over Chapter 9.