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Cost of Capital

Cost of Capital. What is the appropriate discount rate? Capital Structure involves the use of: Optimal Capital Structure:. Debt Financing. Cost of Debt:

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Cost of Capital

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  1. Cost of Capital • What is the appropriate discount rate? • Capital Structure involves the use of: • Optimal Capital Structure:

  2. Debt Financing • Cost of Debt: • Ex. Archer’s Aquarium Equipment currently has bonds outstanding which have 10 years remaining until maturity, offer a semi-annual coupon of $40 (8% coupon rate), and have a $1,000 par value. The bonds currently sell for $975, and Wayne (the CFO) believes he can issue new bonds with a similar yield to maturity. If AAE’s marginal tax rate is 40%, what is their after-tax cost of debt?

  3. Preferred Stock Financing • Cost of Preferred Stock: • Ex.Suppose Archer’s Aquarium Equipment has preferred stock outstanding which offers an annual dividend of $8 per share, and is currently selling for $65.50 per share. If additional shares of preferred stock are issued, the firm must pay floatation costs of 6%. What is Archer’s cost of preferred stock?

  4. Financing Via Retained Earnings • Cost of Retained Earnings: • The CAPM Approach • Ex. Suppose the risk-free rate is 5%, the required rate of return on the market portfolio is 13%, and the Beta coefficient of systematic (market) risk for Archer’s Aquarium Equipment is 0.75. What is AAE’s Ks?

  5. Retained Earnings, cont. • The Bond-Yield plus Risk Premium Approach • Ex. Archer’s Aquarium Equipment has bonds outstanding which yield 8.3740% If you believe the appropriate equity risk premium for AAE is 3%, what is Archer’s required rate of return on retained earnings?

  6. Retained Earnings, cont. • Discounted Cash Flow (DCF) Approach • Ex. Suppose Archer’s Aquarium Equipment recently paid a $3 dividend. In addition, the firm’s dividends are expected to grow by 3% per year, and the company’s stock is currently selling for $40 per share in the marketplace. What is AAE’s cost of retained earnings? • Which estimate of Ks is correct?

  7. Retained Earnings Break Point • Retained Earnings Break Point • Ex. Suppose Archer’s Aquarium Equipment expects to generate $500,000,000 in net income next year. If the firm maintains its current payout ratio of 40%, and current capital structure of 60% equity, 10% preferred stock, and 30% debt, how large of a capital budget can AAE undertake without issuing additional equity?

  8. Weighted Average Cost of Capital (WACC) • Given an optimal capital structure of 60% common equity, 30% debt, and 10% preferred stock, what is Archer’s Aquarium Equipment’s weighted average cost of capital (WACC) for capital budgets between zero and $50 million?

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