Balance Sheet

Assets Side = Financing (Capital Component) Side

Assets = Liabilities +
Assets = Debt +

Theory#1 Firms draw on some combination of equity, debt, and other securities (Capital Structure) to raise
Examples
Assets = Debt +
(a) $ 200,000.00 = $ 50,000.00 +
Weights (percentage) 100% = 25.00% +

(a) $ 200,000.00 = $ 25,000.00 +

Weights (percentage) 100% = 12.50% +

(a) $ 200,000.00 = $ 50,000.00 +

Weights (percentage) 100% = 25.00% +

THE CAPITAL STRUCTURE IS THE PERCENTAGE OF DEBT, PREFERRED STOCK AND COMMON STOCK
THE TARGET CAPITAL STRUCTURE IS THE PERCENTAGE OF DEBT, PREFERRED STOCK AND COMMON

Theory#2 When Firm raise funds it comes with a cost on the Finance (Capital Component) Side. Each of the t
Financing (Capital Component) Side
Debt + Common Shares +
Cost of Debt Cost of Common Shares
Kd Kcs

Theory#3 For Cost of Capital. We are interest in After Tax Cost of Debt
Financing (Capital Component) Side
Debt + Common Shares +
Cost of Debt Cost of Common Shares
Kd (1 - Tax) Kcs

Theory#4 When Firm rasies funds then we need to find the average of the cost of capital. This average in a W
Examples
Assets = Debt +
(a) $ 200,000.00 = $ 50,000.00 +
Weights (percentage) 100% = 25.00% +
Weighted Average of the Cost of Capitals = 25% x K d
(1 - Tax) +
WACC = W d
x K d
(1 - Tax) +
Component) Side
Equities
Common Shares + Preferred Shares

Capital Structure) to raise the funds they need for investment

Common Shares + Preferred Shares

$ 75,000.00 + $ 75,000.00
37.50% + 37.50%

$ 100,000.00 + $ 75,000.00
50.00% + 37.50%

$ 50,000.00 + $ 100,000.00
25.00% + 50.00%

CK AND COMMON STOCK

RED STOCK AND COMMON STOCK THAT MAXIMIZE THE FIRM'S STOCK PRICE

ponent) Side. Each of the these cost is called a Cost of Capital

Preferred Shares
Cost of Preferred Shares
Kps

Preferred Shares
Cost of Preferred Shares
Kps

capital. This average in a Weighted average

Common Shares + Preferred Shares

$ 75,000.00 + $ 75,000.00
37.50% + 37.50%
37.5% x Kcs + 37.5% x Kps
Wcs x Kcs + Wps x Kps
Cost of Common Shares
(a) CAPM (Capital Asset Pricing Model)
Kcs = K = Krf + Beta(Km - Krf)

(b) DDM (Dividend Discount Model)

Kcs = D1/(P - F) + g

(c ) Bond-Yield-Plus-Premium Approach
Kcs = long-term bond yield + risk premium

Cost of Preferred Shares

(a) Kps = D/(P - F)

Cost of Debt
(a) Kd = YTM = m * [ (coupon + (Principal - Price)/nm) / ( (principal + price)/2) ]
coupon = coupon rate x Principal /m
m = compounding period
n = remaining life

Flotation Cost Flotation costs include all costs of issuing the securities, such as banker's fees, legal fees, underwriting
(a) If shares are seasoned, Internal, Retained Earnings the F = 0
(b) If shared are new, external then F <> 0
fees, legal fees, underwriting fees, filing costs
d. Malcolm Technology issued a new series of bonds on January
1, 1985. They were sold at par ($1,000) have a coupon rate of
10% and mature in 20 years. Coupon payments are made semi-
annually.
(i) On July 1, 1995, the bond's price was $990. What was its
yield to maturity on that date?

ANSWER (a)

M= 2
N = 20 - 10.5 = 9.5
Coupon = 10%x$1000/2 = $50.00
Price = $990.00
Face Value = $1,000.00
YTMsemi-annual = ($50+($1000-$990)/(2x9.5)) / ($1000+$990)/2
YTMsemi-annual = 5.08%
YTMannual = 2 x YTMsemi-annual = 2 x 5.08% = 10.16%
 •A firm's weighted average cost will change if one component cost of capital changes.
•This may occur when a firm raises a particularly large amount of capital such that inve
•The WACC of the next dollar of capital raised in called the marginal cost of capital (MC

Breakpoint = Available Funds/ Weight of Capital Component

Sample Question #1

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?
Answer
WACC = Wd x Kd (1 - Tax) + Wcs x Kcs + Wps x Kps

Capital Structure
Debt $ 378.00 Wd 0.42 Kd = 0.09
Common Shares $ 459.00 Wcs 0.51 Kd (1 - Tax) = =0.09*(1-0
Preferred Shares $ 63.00 Wps 0.07 Kcs1 = 0.19
$ 900.00 Kps = 0.15

SINCE QUESTION HAS TWO Kcs THEN THERE IS A BREAKPOINT FOR COMMON SHARE

Breakpoint = Available Funds/ Weight of Capital Component

Breakpoint = 92/ 0.51 = $ 180.39
Total Investment = $ 155.00
Since Total Investent ($155) < Breakpoint ($180.39) then use lower cost of common share
WACC = (0.42 x 0.0495) + (0.51 x 0.17) + (0.07 x 0.15)
WACC = 0.1180
11.80%
 cost of capital changes.
t of capital such that investors think that the firm is riskier.
arginal cost of capital (MCC).

0.0495
Kcs2 = 0.17

(0.07 x 0.15)
 •A firm's weighted average cost will change if one component cost of capital changes.
•This may occur when a firm raises a particularly large amount of capital such that inve
•The WACC of the next dollar of capital raised in called the marginal cost of capital (MC

Breakpoint = Available Funds/ Weight of Capital Component

Sample Question #2

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?
Answer
WACC = Wd x Kd (1 - Tax) + Wcs x Kcs +

Capital Structure
Debt $ 600.00 Wd 0.6 Kd1 (1 - Tax) =
Kcs1 =
Common Shares $ 300.00 Wcs 0.3 Kps =
Preferred Shares $ 100.00 Wps 0.1
$ 1,000.00

SINCE QUESTION HAS TWO Kcs THEN THERE IS A BREAKPOINT FOR COMMON SHARE
SINCE QUESTION HAS TWO Kd THEN THERE IS A BREAKPOINT FOR DEBT
Breakpoint for cshare = 75/ 0.3 = $ 250.00
Breakpoint for debt = 100/ 0.6 = $ 166.67

A
Total Investment = $ 280.00
Since Total Investent ($280) > Breakpoint for cshare ($250) then use higher cost of common share
Since Total Investent ($280) > Breakpoint for debt ($166.67) then use higher cost of debt
WACC = (0.6 x 0.08) + (0.3 x 0.14) +
WACC = 0.0990
9.90%

B
Total Investment = $ 200.00
Since Total Investent ($200) < Breakpoint for cshare ($250) then use lower cost of common share
Since Total Investent ($200) > Breakpoint for debt ($166.67) then use higher cost of debt
WACC = (0.6 x 0.08) + (0.3 x 0.12) +
WACC = 0.0930
9.30%

C
Total Investment = $ 77.00
Since Total Investent ($77) < Breakpoint for cshare ($250) then use lower cost of common share
Since Total Investent ($77) < Breakpoint for debt ($166.67) then use lower cost of debt
WACC = (0.6 x 0.06) + (0.3 x 0.12) +
WACC = 0.0810
8.10%
nt cost of capital changes.
unt of capital such that investors think that the firm is riskier.
marginal cost of capital (MCC).

Wps x Kps

0.06 Kd2 (1 - Tax) = 0.08

0.12 Kcs2 = 0.14
0.09

(0.1 x 0.09)

(0.1 x 0.09)
(0.1 x 0.09)