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Debt and Equity cost

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Chapter 9
The Cost of Capital

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What types of long-term capital do firms use?
Capital components are sources of funding that come from investors
categorized into three types.
Common equity (Stocks)
Preferred stock
Long-term debt (Bonds)
What is the weighted average cost of capital (WACC)?
The weighted average cost of capital (WACC) is the average rate
of return required by all of the company’s investors (stockholders
and creditors).
WACC = W
d
R
d
(1 - t) + W
PS
R
PS
+ W
CE
R
s
Where:
W
d
: Weight of Long-term debt
R
d
: Interest Rate of Debt
t: Tax Rate
W
PS
: Weight of Preferred stock
R
PS
: Interest Rate of Preferred stock
W
CE
: Weight of Common Equity
R
S
: Required rate of return for equity investor
R
s
= RFR + MRP X β
s
OR
R
s
= RFR + (MRR -RFR) X β
s
OR
R
s
= (D
1
/ P
0
) + g
VERY
IMPORTANT

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 Chapter 9 The Cost of Capital What types of long-term capital do firms use? Capital components are sources of funding that come from investors categorized into three types. Common equity (Stocks) Preferred stock Long-term debt (Bonds) What is the weighted average cost of capital (WACC)? The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors). WACC = Wd Rd (1 - t) + WPS RPS + WCE Rs Where: Wd: Weight of Long-term debt Rd: Interest Rate of Debt t: Tax Rate WPS: Weight of Preferred stock RPS: Interest Rate of Preferred stock WCE: Weight of Common Equity RS: Required rate of return for equity investor Rs = RFR + MRP X βs OR Rs = RFR + (MRR -RFR) X βs OR Rs = (D1 / P0 ) + g How do you Determine the Weights for the WACC? The weights are the percentages of the firm that will be financed by each component. Example: Suppose the stock price is $50, there are 3 million shares of stock; the firm has $25 million of preferred stock, and $75 million of debt. Common Equity Value (VCE) = $ 50 (3 million) = $ 150 million. Preferred stock Value (VPS) = $ 25 million. Long-term de ...
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