Explain the following statement: “Preferred stock is a hybrid security”.
Preferred stock is a hybrid security having some characteristics of debt and some of equity. It is similar to bonds in some respects and to common stocks in others. Like bond, preferred stock has a par value and a fixed amount of dividends that must be paid before dividends can be paid on the common stock. However, if the preferred dividends is not earned, the directors can pass it without throwing the company into bankruptcy.
Identify the reasons of calculating the cost of capital used in capital budgeting to be calculated as a weighted average of the various types of funds the firm generally uses, not the cost of the specific financing used to fund a particular project.
The use of debt impacts the ability to use equity, and vice versa, so the weighted average cost must be used to evaluate projects, regardless of the specific financing used to fund a particular project. The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debtholders, so WACC tells us the return that both stakeholders - equity owners and lenders - can expect.
Identify the firms 3 major capital structure components, and give their respective component cost symbols.
There are three major capital components: debt, preferred stock, and common equity.
- component cost of preferred stock
- component cost of common equity
(1-T)=
after-tax component cost of debt, where T is the firm’s marginal
tax rate, -
Explain the reasons of using after-tax cost of debt rather than the before-tax cost in calculating the weighted average cost of capital.
The reason for using the after-tax cost of debt in calculating the weighted average cost of capital is as follows. The value of the firm’s stock, which we want to maximize, depends on after-tax cash flows. Because interest is a deductible expense, it produces tax savings that reduce the net cost of debt, making the after-tax cost of debt less than the before-tax cost. We are concerned with after-tax cash flows, and since cash flows and rates of return should be placed on a comparable basis, we adjust the interest rate downward to take account of the preferential tax treatment of debt.Note that the cost of debt is the interest rate on new debt, not that on already outstanding debt; in other words, we are interested in the marginal cost of debt. Our primary concern with the cost of capital is to use it for capital budgeting decisions—for example, would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant—we need the cost of new capital.