Dulay, Charlene V.

= 1 + +
where:
= % of debt in capital structure
Weights = % of preferred stock in capital structure
= % of common stock in capital structure
= firms cost of debt
Component = firms cost of preferred stock
costs = firms of equity

T = firms corporate tax rate

 Component w k
Debt (before tax) 30% 11.0%
Preferred stock 10% 10.3%
Common equity 60% 14.6%

= 1 + +

= 0.3(11%)(1-.30)+0.1(10.3%)+0.6(14.6%)
= 12.1%
 Book Value Versus Market Value

Historical Versus Target

Given:
The stock price is 50
There are 3 million shares of stock
25 million of preferred stock
75 million of debt

= 50 x (3 million) = 150 million

= 25 million
= 75 million

Total value = 150 + 25 + 75 = 250 million

 Value Weight
Stock Price 50 150,000,000 60%
Share O/S 3,000,000

Preferred Stock 25,000,000 25,000,000 10%

Debt 75,000,000 75,000,000 30%

Total 250,000,000 100%

 Tax Rate = 30% Value Weight Cost of WACC
Capital

Stock Price 50 150,000,000 60% 14.60% 8.76%

Share O/S 3,000,000

Preferred 25,000,000 25,000,000 10% 10.30% 1.03%

Stock

Debt 75,000,000 75,000,000 30% 11.00% 2.31%

Total 250,000,000 100% 12.1%

 Economic value added is used by firms to determine
whether an investment proposed or existing
contributes positively to the shareholders wealth

EVA = Net Operating Profit After Tax (WACC Capital

Employed)
Stark Industries' earnings before interest and taxes for
the financial year 2011 amounted to 5 million.
Applicable tax rate is 30%. 60% of the company's assets
are financed by debt which has an after tax cost of
3.8%, while 40% is financed by equity with a cost of
9.8%. Stark Industries average total capital employed
over the period amounted to 1.3 million. Find Stark
Industries' economic value added.
 Economic Value Added = NOPAT (WACC
Capital Employed)

NOPAT = EBIT (1 Tax Rate)

= 5 million (1 .30)
= 3.5 million

WACC = 0.6 3.8% + 0.4 9.8%

= 6.2%

EVA= 3.5 million (6.2% 1.3 million) = 3,419,400

 The firms weighted average cost of capital will change
if one component cost of capital changes.

The WACC of the next peso of capital raised is called

the marginal cost of capital (MCC).

=

Where
= breakpoint for financing source j
= amount of funds available for financing source j at a given cost
= capital structure weight for financing source j

Assume that the weight of an equity as a source of capital in the companys

capital structure is 50%. The company has 100,000 of retained earnings left
at a cost of 15%. Thereafter, they can issue new common stock at a cost of
16.25%.

100,000
= = ,
.50
Range of total new Source of Weight Cost Weighted
financing capital cost
0 to 200,000 Debt .40 10% 2.4%
Preferred .10 11.9% 1.19%
Common .50 15% 7.5%
Weighted average cost of capital 11.09%
200,000 and above Debt .40 10% 2.4%
Preferred .10 11.9% 1.19%
Common .50 16.25% 8.13%
Weighted average cost of capital 11.72%
Investment Internal Rate Initial Cumulative
Opportunity of Return Investment Investment
(IRR)
1 12.4 100,000 100,000
2 12.1 150,000 250,000
3 11.5 100,000 350,000
Marginal weighted cost of capital curve:
Weighted Cost of Capital
13%

12% 11.72%
11.09%
11%
Using internal Using new
common equity common equity
10%

0 100,000 200,000 300,000 400,000

Total Financing
 Graph IRRs of potential projects

Marginal weighted cost of capital curve:

Weighted Cost of Capital
12%

11% Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing
 Graph IRRs of potential projects
Graph WMCC Curve

Marginal weighted cost of capital curve:

11.72%
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = Project 2 Project 3
10% 12.4% IRR = IRR =
12.1% 11.5%
9%

0 100,000 200,000 300,000 400,000

Total Financing
 Graph IRRs of potential projects
Graph WMCC Curve
Accept projects up to the point at which IRR equals the weighted
marginal cost of capital
Marginal weighted cost of capital curve:

11.72% WMCC
Weighted Cost of Capital

12%
11.09%
11% Project 1
IRR = 12.4% Project 2 Project 3
10% IRR = 12.1% IRR = 11.5%

9% Accept Projects #1 & #2

0 100,000 200,000 300,000 400,000
Total Financing