10 — 1 10 — 2 Coleman

10 - 1

10 - 2 Coleman Technologies

10 - 3 Coleman Technologies

10 - 4 Coleman Technologies The firm’s target capital structure is: 30 percent long-term debt; 10 percent preferred stock; and 60 percent common equity.

10 - 5 What are the sources of capital for firms? Debt Preferred stock Common equity: Retained earnings New common stock

10 - 6 Should we focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

10 - 7 . . .

10 - 8 Component Cost of Debt

10 - 9 Use this formula:

10 - 10 Picture of Preferred Stock. . . $2. 50 $111. 10

10 - 11 Note:

10 - 12 Why is there a cost for retained earnings?

10 - 13

10 - 14

10 - 15

10 - 16 $4. 19(1. 05) $50

10 - 17 Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue. What’s the expected future g?

10 - 18 Retention growth rate: g = (1 – Payout)(ROE) = 0. 35(15%) = 5. 25%. Here (1 – Payout) = Fraction retained. Close to g = 5% given earlier.

10 - 19 Could DCF methodology be applied if g is not constant?

10 - 20

10 - 21

10 - 22 Why is the cost of retained earnings cheaper than the cost of issuing new common stock? 1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.

10 - 23 Two approaches that can be used to account for flotation costs:

10 - 24 New common, F = 15%:

10 - 25 Comments about flotation costs:

10 - 26 What’s the firm’s WACC (ignoring flotation costs)?

10 - 27 What factors influence a company’s composite WACC?

10 - 28 WACC Estimates for Some Large U. S. Corporations, Nov. 1999

10 - 29 Should the company use the composite WACC as the hurdle rate for each of its projects?

10 - 30 Risk and the Cost of Capital

10 - 31 Divisional Cost of Capital

10 - 32 What are three types of project risk?

10 - 33 How is each type of risk used?

10 - 34 What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?

10 - 35 Methods for Estimating a Project’s Beta 1. Pure play. Find several publicly traded companies exclusively in project’s business. Use average of their betas as proxy for project’s beta. Hard to find such companies.

10 - 36 2. Accounting beta. Run regression between project’s ROA and S&P index ROA. Accounting betas are correlated (0. 5 – 0. 6) with market betas. But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.

10 - 37 Find the division’s market risk and cost of capital based on the CAPM, given these inputs:

10 - 38

10 - 39 How does the division’s market risk compare with the firm’s overall market risk?