What sources of longterm capital do firms use

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What sources of long-term capital do firms use?
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Cost of Capital Terms   Kd       Kd(1-T)      
Kps     Ks     WACC  
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Cost of Debt   Investors demand Kd   After tax
cost of Debt Revenues -Expenses -Depreciation EB
IT -Interest expense EBT -Taxes EAT (NI)
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Cost of Preferred stock
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Cost of Retained Earnings   CAPM                
    Bond-Yield-plus-risk-Premium approach  
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DCF                       g (Retention
rate)(ROE)            
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Cost of Newly issued Common Stock (External
equity)   Ke            
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Assume a firm has 100,000 in assets financed
with 100 equity, it earns 15 on assets but pays
out all earnings. The firm has 1,000 shares of
stock, therefore Po 100. EPS DPS 15
100 15   Now suppose our firm wants to issue
an additional 1,000 shares of stock. It can sell
new stock at the current price of 100/sh, with a
10 float cost going to the banker. Firm
gets           
10

• Total assets 
• return
•   
• New EPS
•  

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New Po         Ke D1/Po(1-F)
g                  
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How are the weights determined?

• WACC wdkd(1-T) wpkp wcks
• Use accounting numbers or market value (book vs.
  market weights)?
• Use actual numbers or target capital structure?

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MCC Marginal Cost of Capital
                          Retained earnings
break point Assume we only have 50,000 in
retained earnings available, and that we want to
keep our cap-structure  
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(debt 40, Pref 10, equity 50) How many dollars
of capital can we raise before   We want to
raise 200,000.   So our initial coast of
capital is .4(Kd)(1-T) .1(Kps)
.5(Kre) .4(8((1-.4) .1 (10)
.5(13.5)     but we will run out of retained
earnings at some point. Equity 50 of our
capital .5(200,000) 100,000 total
needed   But we only have 50,000 in
RE     50,000 .5(BP)  
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After that we will have to issue now stock/equity
if we wish to maintain our capital structure of
40/10/50.   New equity costs more due to float
costs 14.2   WACC .4(Kd)(1-T) .1(Kd)
.5(Ke) .4(8)(1-.4) .1(10)
.5(14.2)       MCC Schedule
WACC
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Factors the effect cost of capital Interest
rates     Tax rates       Capital Structure
Policy         Dividend Policy  
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Investment Policy In what type of projects will
we be investing?         How do we use the MCC in
deciding which projects to invest.   1. Look at
what projects are available. 2. Estimate cash
flow from each project. 3. Use TVM to see if PV
is positive. 4. If PV is positive, what is the
Expected rate of return. Rank all () projects in
order of ERR( IRR)   Graph amounts and rates on
the MCC schedule.  
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Should the company use the composite WACC as the
hurdle rate for each of its projects?

• NO! The composite WACC reflects the risk of an
  average project undertaken by the firm.
  Therefore, the WACC only represents the hurdle
  rate for a typical project with average risk.
• Different projects have different risks. The
  projects WACC should be adjusted to reflect the
  projects risk.

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Risk and the Cost of Capital
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