QUESTION 3 See details for each of the costs of financing from section 10-3, 10-4, 10-5, and 10-6 Here is a concept clip: Cengage Concept Clip Link - When a firm uses debt financing, it needs to find the A. Dividend (D) / Price (P) (this is from Chapter 9) cost of this source. When debt is used the interest B. The Yield to Maturity (I/Y) on current or recent on that debt is a cost for the firm. So how do we measure the anticipated interest payment on new outstanding bonds (this is from Chapter 8) debt? C. The cost of new equity issuance (issuing new stock) is It is approximated with which variable? higher than the cost of equity from retained earnings. This means when flotation cost is considered the - When a firm uses preferred stock financing, it needs should be larger than equity from retained earnings. to find the cost of this source. Investors will not be willing to invest in the firm or project unless their D. The cost of equity can be the cost of retained earnings or required return threshold is met. For example, I the cost of new common stock. would not invest in any stock if I thought there was a When you see "cost of common equity" or "cost of good chance that I would lose money. So how can equity" know that there are three methods for we measure the required return of investors on approximating this value. What are the three ways to preferred stock? measure cost of equity CAPM approach in 10-5A - this method uses beta (see chapter 8 for a refresher of the CAPM) Bond Yield + Risk Premium Approach This method uses a Risk Premium that represents the additional required return from investing in stocks over bonds- In this method the Bond Risk Premium is given in the problem set-up. The Bond Yield can be found as the yield to maturity on the firm's debt (I/Y) Investors require more return for investing in stocks over bonds because common stocholders are behind bondholders and bankruptcy claimants This Risk Premium is different than the "Market Risk Premium" used in the CAPM. Remember the Market Risk Premium is the the extra required return from investing in the market over the risk free rate. The Discounted Cash Flow (DCF) approach uses the valuation model from Chapter 9 where now we solve for (r) This appoximation method uses dividends Be careful that the Upcoming Dividend is used in the formula. Investors consider future cash flows in these models. So be careful in using dividends in this formula. D1 = DO *(1+g) where g is in decimal form The cost of NEW common equity considers the cost of new issuance in its approximation. These are called flotation costs and can be significant In this class flotation cost will be provided as a percentage and will only be used with the DCF method. The steps for considering this added cost to using equity is in section 10-6b of the book One of the cengage homework questions instructs you to calculate the cost of equity with and without flotaiton costs just as in section 10-6b Match this to the statement that is true when we consider flotation cost
