530Mod6a

 

Session 9 - Weighted Average Cost of Capital, Chapter 9

All page numbers are references to Corporate Finance: A Focused Approach 7th edition by Ehrhardt and Brigham (Cengage Learning, 2020)

Chapter 9

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 previously learned in Chapters 5-7.

Things to Absorb-

All of the general material to estimate Cost of Capital, including after-tax cost of debt, cost of preferred stock, and the two methods of calculating the cost of common equity. Understand how to calculate all of the components of equation 9-2 on page 375. 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 concepts related to risk and return, as this topic is often the source of concept questions. Section 11b discusses how to make project and division WACC adjustments, and is often a source of exam questions. Section 13 is a good source of concept questions. I will use this chapter to relate Risk and Return for Capital Budgeting problems, so expect to see this again in Chapter 10 and 11 materials in the quizzes.

Things You Do Not Need to Absorb

Section 10 on WACC for small and private companies. Section 11a on factors the firm cannot control. 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 flotation costs should have a low priority. Flotation costs could appear in quiz questions.

Things to Read

Read Chapter 9.

Things to Do

Make 100 on the quiz. Be able to solve Concept Review Questions 1-5 (all of them), and Problems 1-12, 15-17 (ignoring issues related to flotation costs). For my face to face classes, my Final Exam questions are often similar to Self-Test 1 and Problems 15 or 16. For my on line classes, the questions are  more likely to be 3-4 separate questions, such as Problems 3, 5, 6, 7, 8, 9.  If using Excel, use the Chapter 9 Toolkit.

Calculator links

Simple and useful instructions for most calculators

  1. Watch the Chapter Introduction and Overview video. The Powerpoints for all of this chapter's videos are located here.
  2. Read pages 375-384.
  3. Watch the video, WACC Overview, Costs of Debt, and Cost of Preferred Stock (minicase pages 408-410, parts a-c). After this video, you should be able to answer end of chapter Questions 1 and 2 and Problems 1, 2, and 9.
  4. Read pages 384-393.
  5. Watch the video Costs of Common Stock (minicase, parts d-g). After this video, you should be able to answer end of chapter Questions 3 and 4 and Problems 3-6, and 10-12.
  6. Read pages 393-397.
  7. Watch the video Weights and Calculations of the WACC (minicase, parts h, i). After this video, you should be able to solve Problems 15 and 16.
  8. Read the remaining part of the chapter.
  9. Watch the video on Adjusting for Project Risk, Divisional Costs of Capital, and Odds and Ends (minicase, parts j-p). After this video, you should be able to solve the remaining suggested questions and problems.
  10. Below are audio solutions, courtesy of Dr. Ronald Best, to problems that are similar to those covered in this chapter;
    1. 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?  Audio Solution
    2. 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?  Audio Solution
    3. 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?  Audio Solution
    4. 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?  Audio Solution
    5. 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?  Audio Solution
    6. 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?  Audio Solution
    7. 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?  Audio Solution
    8. 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?  Audio Solution
    9. 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?  Audio Solution
    10. 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?  Audio Solution
  11. Be prepared for a 40-60 minute quiz over Chapter 9.

Modified September 18, 2020
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