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Irwin/McGraw-HillChapter11FundamentalsofCorporateFinanceThirdEditionTheCostofCapitalBrealeyMyersMarcusslidesbyMatthewWillIrwin/McGraw-HillTheMcGraw-HillCompanies,Inc.,2001TopicsCoveredGeothermal’sCostofCapitalWeightedAverageCostofCapital(WACC)CapitalStructureRequiredRatesofReturnBigOil’sWACCInterpretingWACCFlotationCostsCostofCapitalCostofCapital-Thereturnthefirm’sinvestorscouldexpecttoearniftheyinvestedinsecuritieswithcomparabledegreesofrisk.CapitalStructure-Thefirm’smixoflongtermfinancingandequityfinancing.CostofCapitalExample

GeothermalInc.hasthefollowingstructure.Giventhatgeothermalpays8%fordebtand14%forequity,whatistheCompanyCostofCapital?CostofCapitalExample-GeothermalInc.hasthefollowingstructure.Giventhatgeothermalpays8%fordebtand14%forequity,whatistheCompanyCostofCapital?CostofCapitalExample-GeothermalInc.hasthefollowingstructure.Giventhatgeothermalpays8%fordebtand14%forequity,whatistheCompanyCostofCapital?CostofCapitalExample-GeothermalInc.hasthefollowingstructure.Giventhatgeothermalpays8%fordebtand14%forequity,whatistheCompanyCostofCapital?Interestistaxdeductible.Givena35%taxrate,debtonlycostsus5.2%(i.e.8%x.65).WACCWeightedAverageCostofCapital(WACC)-Theexpectedrateofreturnonaportfolioofallthefirm’ssecurities.Companycostofcapital=Weightedaverageofdebtandequityreturns.WACCWACCThreeStepstoCalculatingCostofCapital1.Calculatethevalueofeachsecurityasaproportionofthefirm’smarketvalue.2.Determinetherequiredrateofreturnoneachsecurity.3.Calculateaweightedaverageoftheserequiredreturns.WACCTaxesareanimportantconsiderationinthecompanycostofcapitalbecauseinterestpaymentsaredeductedfromincomebeforetaxiscalculated.

WACCWeighted-averagecostofcapital=WACCExample-ExecutiveFruithasissueddebt,preferredstockandcommonstock.Themarketvalueofthesesecuritiesare$4mil,$2mil,and$6mil,respectively.Therequiredreturnsare6%,12%,and18%,respectively.Q:DeterminetheWACCforExecutiveFruit,Inc.WACCExample-continuedStep1 FirmValue=4+2+6=$12milStep2 RequiredreturnsaregivenStep3WACCIssuesinUsingWACCDebthastwocosts.1)returnondebtand2)increasedcostofequitydemandedduetotheincreaseinriskBetasmaychangewithcapitalstructureCorporatetaxescomplicatetheanalysisandmaychangeourdecision

MeasuringCapitalStructureInestimatingWACC,donotusetheBookValueofsecurities.InestimatingWACC,usetheMarketValueofthesecurities.BookValuesoftendonotrepresentthetruemarketvalueofafirm’ssecurities.MeasuringCapitalStructureMarketValueofBonds-PVofallcouponsandparvaluediscountedatthecurrentinterestrate.MarketValueofEquity-Marketpricepersharemultipliedbythenumberofoutstandingshares.MeasuringCapitalStructureMeasuringCapitalStructureIfthelongtermbondspayan8%couponandmaturein12years,whatistheirmarketvalueassuminga9%YTM?MeasuringCapitalStructureRequiredRatesofReturnBondsCommonStockRequiredRatesofReturnDividendDiscountModelCostofEquityPerpetuityGrowthModel=solveforreRequiredRatesofReturnExpectedReturnonPreferredStockPriceofPreferredStock=solveforpreferredFlotationCostsThecostofimplementinganyfina

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