Chapter 09

Chapter9
TheCostofCapital
Instructors Resources
Overview
Thischapterintroducesthestudenttoanimportantfinancialconcept,thecostofcapital.Themechanicsof
computingthesourcesofcapitaldebt,preferredstock,commonstock,andretainedearningsarereviewed.
Theseindividualcostsarethencombinedintoaweightedaveragecostofcapital.Studentsareencouraged
todevotetimeandefforttolearningChapter9smaterialsbecauseacceptableprojectsencounteredintheir
professionallifeorinvestmentdecisionsmadeintheirpersonallifewillbecorrectiftheyearnareturn
higherthanthecostofcapital.
Suggested Answers to Opener in Review Questions

SupposethatGEcoulduse$1billiontomakeaninvestmentthatwouldgenerateapositivecashflow
of$60millioneveryyearinperpetuity.Ata5%discountrate,whatwouldbethevalueofthiscash
flowtoinvestor?HowmuchwouldsuchaninvestmentaddtoGEsmarketvalue?
Withoutanygrowth,allonehastodoisdividethecashflowbythediscountrate,usinganequationthatis
similartothatemployedtovaluepreferredstock.Thepresentvalueofthecashinflowsis$1.2billion
($600.05).Subtractingthecostoftheinvestment,GEsvalueandsharepriceshouldincreaseby
$200million.
Nowsupposethattheinvestmentactuallyproducesjust$10millionperyearinperpetuity(orabout
1%peryearrelativetotheinvestment).Whatisthevalueofthisinvestmenttoshareholders,andby
howmuchwouldGEsmarketvaluefallbecauseofthisinvestment?
Alowerreturnwillreducethepresentvalueofthecashinflowsby$1billion,to$200million($100.05).
InthiscasethemarketvalueofGEwoulddropby$800million,whichistheexcessofthecostrelativeto
thepresentvalueoftherevenuestream.
Answers to Review Questions
Chapter9TheCostofCapital175
1. Thecostofcapitalrepresentsthefirmscostoffinancinginpercentageterms.Afirmscostofcapital
istheexpectedaveragefuturecostoffundsoverthelongrun.Itistherateofreturnafirmmustearn
onitsinvestmentinordertomaintainthemarketvalueofitsstock.
Inordertomakeanysuchfinancingdecision,theoverallcostofcapitalmustbeconsidered.This
resultsfromtheinterrelatednessoffinancingactivities.Forexample,afirmraisingfundswithdebt
todaymayneedtouseequitythenexttime,andthecostofequitywillberelatedtotheoverallcapital
structure,includingdebt,ofthefirmatthetime.
2012PearsonEducation,Inc.PublishingasPrenticeHall
2. Thecostofcapitalprovidesabenchmarkagainstwhichthepotentialrateofreturnonaninvestment
iscompared.Financialmanagersshouldonlyinvestinprojectsthatareexpectedtoprovidearateof
returninexcessofthecostofcapital.Selectionofprojectswithreturnsinexcessofthecostofcapital
increasesfirmvalue.Theselectionofallprojectswithexpectedreturnsthatareequalorgreatertothe
firmscostofcapitalmaximizesshareholderwealth.Capitalbudgetingistheprocessofevaluating
andselectinglongterminvestmentsthatexceedthecostofcapitalandtherebymaximizeshareholder
wealth.
3. Capitalstructureconsistsoflongtermsourcesoffinancing,comingfrombondholdersand
stockholders.Thecostofeachsourceoffinancingisweightedbytheproportionoflongtermfunds
thatcomefromthatsourceoffinancing.Thelongrunaverageamountoffinancingfromeachof
thesesourcesrepresentsthetargetcapitalstructure.Whenthecostofeachsourceoffinancingis
multipliedbytheproportionateamountinthecapitalstructure,theaggregateisthefirmsweighted
averagecostofcapital.Ultimately,itisthemarginal,orincremental,costofcapitalnecessarytoraise
thenextmarginaldollaroffinancingthatisrelevantformakinginvestmentdecisions.
4. Thefourbasiclongtermsourcesofcapitalavailabletofirmsarelongtermdebt,preferredstock,
commonstock,andretainedearnings.Commonstockreferstotheamountobtainedbythefirm
throughtheissuanceofshares,eitherinaninitialpublicofferingorsubsequentstocksale.
Theuseoftheweightedaveragecostofcapitalisrecommendedoverthecostofthesourceoffunds
tobeusedfortheproject.Theinterrelatednessoffinancingdecisionsassumingthepresenceofa
targetcapitalstructureisreflectedintheweightedaveragecostofcapital.
5. Thenetproceedsfromthesaleofabondarethefundsreceivedfromitssaleafterallunderwriting
andbrokeragefeeshavebeenpaid.Abondsellsatadiscountwhentherateofinterestcurrentlypaid
onsimilarriskbondsisabovethebondscouponrate.Bondssellatapremiumwhentheircoupon
rateisabovetheprevailingmarketrateofinterestonsimilarriskbonds.
Flotationcostsarefeeschargedbyinvestmentbankingfirmsfortheirservicesinassistinginselling
thebondsintheprimarymarket.Thesecostsreducethetotalproceedsreceivedbythefirmsincethe
feesarepaidfromthebondfunds.
6. Thethreeapproachestofindingthebeforetaxcostofdebtare:
a.
Thequotationapproachthatusesthecurrentmarketvalueofabondtodeterminetheyieldto
maturityonthebond.Ifthemarketpriceofthebondisequaltoitsparvaluetheyieldtomaturity
isthesameasthecouponrate.
b. Thecalculationapproachfindsthebeforetaxcostofdebtbycalculatingtheinternalrateof
return(IRR)onthebondcashflows.
c.
Theapproximationapproachusesthefollowingformulatoapproximatethebeforetaxcostof
thedebt.
rd
[($1,000 N d )]
n
( N d $1,000)
2
177Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
where:
theannualinterestpaymentindollars
Nd thenetproceedsfromthesaleofabond
n thetermofthebondinyears
Thefirstpartofthenumeratoroftheequationrepresentstheannualinterest,andthesecondpart
representstheamortizationofanydiscountorpremium;thedenominatorrepresentstheaverage
amountborrowed.
7. Thebeforetaxcostisconvertedtoanaftertaxdebtcost(ri)byusingthefollowingequation:
rird(1T),whereTisthefirmstaxrate.
8. Thecostofpreferredstockisfoundbydividingtheannualpreferredstockdividendbythenet
proceedsfromthesaleofthepreferredstock.Theformulais:
rp
where:
Dp
Np
Dptheannualdividendpaymentindollars
Npthenetproceedsfromthesaleofthepreferredstock
9.
TheCAPMtechniquedirectlyconsidersthefirmsrisk,throughitsinclusionofabetaterm,in
determiningtherequiredrateofreturnoncommonstockholders.Bycontrast,theconstantgrowth
modelusesthemarketpriceinthedenominator.Thispriceisanindicationoftheexpectationsof
investorsinthemarketplaceregardingriskandreturn.
10. Theassumptionsunderlyingtheconstantgrowthvaluation(Gordon)modelare:
a.
ThevalueofashareofstockisthePVofalldividendsexpectedtobepaidoveritslife.
b. Therateofgrowthofdividendsandearningsisconstant,whichmeansthatthefirmhasafixed
payoutratio.
c. Firmsperceivedbyinvestorstobeequallyriskyhavetheirexpectedearningsdiscountedatthe
samerate.
11. Thecostofretainedearningsistechnicallylessthanthecostofnewcommonstock,sincebyusing
retainedearnings(cash)thefirmavoidsunderwritingcosts,aswellaspossibleunderpricingcosts.
12. Theweightedaveragecostofcapital(WACC),ra,isanaverageofthefirmscostoflongterm
financing.Itiscalculatedbyweightingthecostofeachspecifictypeofcapitalbyitsproportionin
thefirmscapitalstructure.Theweightsmustbenonnegativeandsumto1.0.
13. Theweightedaveragecostofcapital(WACC),ra,ishighlydependentuponthefirmstargetcapital
structure.Astheproportionoffinancingarisingfromaspecificsourcerises,theimportanceofthe
costofthatsourceoffinancingrisesalso.Initiallyprojectsarefundedwithretainedearnings,which
ischeaperbecauseitdoesnotincludeafloatationcost.However,astheamountoffundingfrom
commonstockholdersrises,thefirmismorelikelytorequireexternalfinancing.Thecommon
stockholdersportionoftheweightedaveragecostofcapitalwilleithercomefromretainedearnings
orexternalfinancing,notboth.
14. Usingtargetcapitalstructureweights,thefirmistryingtodevelopacapitalstructurethatisoptimal
forthefuture,givenpresentinvestorattitudestowardfinancialrisk.Targetcapitalstructureweights
aremostoftenbasedondesiredchangesinhistoricalbookvalueweights.Unlesssignificantchanges
areimpliedbythetargetcapitalstructureweights,littledifferenceintheweightedmarginalcostof
capitalresultsfromtheiruse.
Suggested Answer to Focus on Practice Box: Uncertain Times Make

for an Uncertain Weighted Average Cost of Capital
Whydontfirmsgenerallyusebothashortandlongrunweightedaveragecostofcapital?
Firmsmaximizeshareholderwealththroughinvestmentinfixedassets.Capitalbudgetingistheprocessof
evaluatingandselectingtheseassets,whichareutilizedformorethanayear.Mismatchingofassetlife
andfinancingdurationincreasesfinancialrisk.
Shorttermborrowingisfrequentlycheaperthanlongtermsourcesoffundingbecausetheshortterm
lenderknowsthatthelongtermsourcesofcapitalbackuptheloan.ThisboxreportsthatCaraustaruses
bothashorttermandlongtermcostofcapital,whichriseswiththelengthofthedebtusedinestimating
thecostofcapital.Fromaoperationalstandpoint,thiswouldbedifficultbecauseshorttermratesarequite
volatile.Hence,projectsthatareunacceptableonemonthmightbeacceptablethenext.Thefinancial
managerwouldhavetoupdateanddisseminateinformationonthecurrentshorttermcostofcapital.
Anotherreasonmostcompaniesdonotoperatewithashorttermandlongtermcostofcapitalisthatdebt
isonlyafraction(andinmanycompaniesasmallfraction)ofthefinancing.Also,tobeaccurate,one
wouldhavetoconsiderthefactthatstockholderswouldincreasetheirrequiredrateofreturniftheywere
awarethatthedebtbeingusedwasshortterm,becauseloanexpirationoccursmorequickly,shortterm
interestratesaremorevolatileandcouldbehigher,andthecompanymayfinditdifficulttofindalender.
Hence,theadvantageofusingshorttermdebtinaWACCmaynotbeasdramaticasobservedtobyMr.
Domanico.Oneshouldconsiderfinancialinterrelationshipsoverthelongrun.
Suggested Answer to Focus on Ethics Box: The Ethics of Profit

TheVioxxrecallincreasedMerckscostofcapital.Whateffectwouldanincreasedcostofcapital
haveonafirmsfutureinvestments?
Foraninvestmenttobeworthwhileforafirm,theexpectedreturnmustbegreaterthanthecostofcapital.
Whenafirmscostofcapitalincreases,ithasthepotentialtomakeinvestmentopportunitiesthatonce
appearedattractivetothefirmsuddenlyunattractive.
Answers to Warm-Up Exercises

E91.
Weightedaveragecostofcapital
Answer:
N10,PV$20,000(10.02)$19,600,PMT0.08$20,000$1,600,FV$20,000
SolveforI8.30%
E92.
Costofpreferredstock
Answer: Thecostofpreferredstockistheratioofthepreferredstockdividendtothefirmsnet
proceedsfromthesaleofthepreferredstock.
rpDpNp
rp(0.15$35)($35$3)
rp$5.25$3216.4%
E93.
Costofcommonstockequity
Answer: Thecostofcommonstockequitycanbefoundbydividingthedividendexpectedattheendof
year1bythecurrentpriceofthestockandaddingtheexpectedgrowthrate.
rs(D1P0)g
rs($6.50$78)7%15.33%
E94.
Answer: ra(0.350.08)(0.650.13)0.02800.084511.25%
E95.
Answer: ra(0.550.067)(0.100.092)(0.350.106)0.08328.32%
Solutions to Problems
P91.
Conceptofcostofcapital
LG1;Basic
a.
Thefirmisbasingitsdecisiononthecosttofinanceaparticularprojectratherthanthefirms
combinedcostofcapital.Thisdecisionmakingmethodmayleadtoerroneousaccept/reject
decisions.
b.
rawdrdwere
ra0.40(7%)0.60(16%)
ra2.8%9.6%
ra12.4%
P92.
c.
Rejectproject263.Acceptproject264.
d.
Oppositeconclusionsweredrawnusingthetwodecisioncriteria.Theoverallcostofcapital
asacriterionprovidesbetterdecisionsbecauseittakesintoconsiderationthelongrun
interrelationshipoffinancingdecisions.
Costofdebtusingbothmethods
LG3;Intermediate
a.
Netproceeds:Nd$1,010$30
Nd$980
b.
Cashflows:
T
0
115
15
CF
$980
120
1,000
c.
Costtomaturity:
N15,P980,PMT120,FV1,000
SolveforI:12.30%
Aftertaxcost:12.30%(10.4)7.38%
d.
Approximatebeforetaxcostofdebt
rd
($1,000 $980)
15
($980 $1,000)
2
$120
rd$121.33$990,000
rd12.26%
Approximateaftertaxcostofdebt12.26%(10.4)7.36%
e.
P93.
Theadvantagesofthecalculatormethodareevident.Therearefewerkeypunching
strokesandonegetstheactualcostofdebtfinancing.However,theapproximation
formulaisfairlyaccurateandexpedientintheabsenceofafinancialcalculator.
Beforetaxcostofdebtandaftertaxcostofdebt
LG3;Easy
a.
N10,PV930(anexpenditure),PMT0.6(1,000)60,FV1,000
SolvingforI7.00%
b. Usethemodel:Aftertaxcostofdebtbeforetaxcostofdebt(1taxbracket)
7.0%(10.2)5.6%
P94.
Costofdebtusingtheapproximationformula:
LG3;Basic
rd
$1,000 N d
n
N d $1,000
2
rird(1T)
BondA
rd
$1,000 $955
$92.25
20
9.44%
$955 $1,000
$977.50
2
$90
ri9.44%(10.40)5.66%
BondB
rd
$1,000 $970
$101.88
16
10.34%
$970 $1,000
$985
2
$100
ri10.34%(10.40)6.20%
BondC
rd
$1,000 $955
$123
15
12.58%
$955 $1,000
$977.50
2
$120
ri12.58%(10.40)7.55%
BondD
rd
$1,000 $985
$90.60
25
9.13%
$985 $1,000
$992.50
2
$90
ri9.13%(10.40)5.48%
BondE
rd
$1,000 $920
$113.64
22
11.84%
$920 $1,000
$960
2
$110
ri11.84%(10.40)7.10%
P95.
Costofdebtusingtheapproximationformula
LG3;Intermediate
rd
$1,000 N d
n
N d $1,000
2
rird(1T)
AlternativeA
rd
$1,000 $1,220
$76.25
16
6.87%
$1,220 $1,000
$1,110
2
$90
ri6.87%(10.40)4.12%
Calculator:N16,PV$1,220,PMT$90,FV$1,000
SolveforI:6.71%
Aftertaxcostofdebt:4.03%
AlternativeB
rd
$1,000 $1,020
$66.00
5
6.54%
$1,020 $1,000
$1,010
2
$70
ri6.54%(10.40)3.92%
Calculator:N5,PV$1,020,PMT$70,FV$1,000
SolveforI:6.52%
AlternativeC
rd
$1,000 $970
$64.29
7
6.53%
$970 $1,000
$985
2
$60
ri6.53%(10.40)3.92%
Calculator:N7,PV$970,PMT$60,FV$1,000
SolveforI:6.55%
AlternativeD
rd
$1,000 $895
$60.50
10
6.39%
$895 $1,000
$947.50
2
$50
ri6.39%(10.40)3.83%
Calculator:N10,PV$895,PMT$50,FV$1,000
SolveforI:6.46%
P96.
Aftertaxcostofdebt
LG3;Intermediate
a.
Sincetheinterestontheboatloanisnottaxdeductible,itsaftertaxcostequalsitsstatedcost
of8%.
b. Sincetheinterestonthesecondmortgageistaxdeductible,itsaftertaxcostisfoundby
multiplyingthebeforetaxcostofdebtby(1taxrate).Beinginthe28%taxbracket,the
aftertaxcostofdebtis6.6%9.2%(10.28).
c.
Homeequityloanhasaloweraftertaxcost.However,usingthesecondhomemortgagedoes
puttheStarksatriskoflosingtheirhomeiftheyareunabletomakethemortgagepayments.
P97.
Costofpreferredstock:rpDpNp
LG2;Basic
rp
$12.00
12.63%
$95.00
rp
$10.00
11.11%
$90.00
a.
b.
P98.
Costofpreferredstock:rpDpNp
LG4;Basic
PreferredStock
A
B
C
D
E
P99.
rp
rp
rp
rp
rp
Calculation
$11.00 $92.00
3.20 34.50
5.00 33.00
3.00 24.50
1.80 17.50
11.96%
9.28%
15.15%
12.24%
10.29%
Costofcommonstockequitycapitalassetpricingmodel(CAPM)
LG5;Intermediate
rsRF[b(rmRF)]
rs6%1.2(11%6%)
rs6%6%
rs12%
a.
Riskpremium6%
b. Rateofreturn12%
c.
AftertaxcostofcommonequityusingtheCAPM12%
D1 g
Nn
kn
P910. Costofcommonstockequity:
LG5;Intermediate
a.
N4(20122008),PV(initialvalue)$2.12,FV(terminalvalue)$3.10
SolveforI(growthrate):9.97%
b. Nn$52(givenintheproblem)
c.
rr(NextDividendCurrentPrice)growthrate
rr($3.40$57.50)0.0997
rr0.05910.09970.1588or15.88%
d. rr($3.40$52)0.0997
rr0.06540.09970.1651or16.51%
P911. Retainedearningsversusnewcommonstock
LG5;Intermediate
rr
D1
g
P0
Firm
A
rn
D1
g
Nn
Calculation
rr($2.25 $50.00)8%12.50%
rn($2.25$47.00)8%12.79%
rr($1.00$20.00)4%9.00%
rn($1.00$18.00)4%9.56%
rr($2.00$42.50)6%10.71%
rn($2.00$39.50)6%11.06%
rr($2.10$19.00)2%13.05%
rn($2.10$16.00)2%15.13%
P912. EffectoftaxrateonWACC
LG3,4,5,6;Intermediate
a.
WACC(0.30)(11%)(10.40)(0.10)(9%)(0.60)(14%)
WACC1.98%0.9%8.4%
WACC11.28%
b.
WACC(0.30)(11%)(10.35)(0.10)(9%)(0.60)(14%)
WACC2.15%0.9%8.4%
WACC11.45%
c.
WACC(0.30)(11%)(10.25)(0.10)(9%)(0.60)(14%)
WACC2.48%0.9%8.4%
WACC11.78%
d.
Asthetaxratedecreases,theWACCincreasesduetothereducedtaxshieldfromthetax
deductibleinterestondebt.
P913. WACCbookvalues
LG6;Basic
a.
TypeofCapital
LTdebt
Preferredstock
Commonstock
BookValue
$700,000
50,000
650,000
$1,400,000
Weight
0.500
0.036
0.464
1.000
Cost
5.3%
12.0%
16.0%
WeightedCost
2.650%
0.432%
7.424%
10.506%
b. TheWACCistherateofreturnthatthefirmmustreceiveonlongtermprojectstomaintain
thevalueofthefirm.Thecostofcapitalcanbecomparedtothereturnforaprojectto
determinewhethertheprojectisacceptable.
P914. WACCbookweightsandmarketweights
LG6;Intermediate
a.
Bookvalueweights:
TypeofCapital
LTdebt
Preferredstock
Commonstock
BookValue
$4,000,000
40,000
1,060,000
$5,100,000
Weight
0.784
0.008
0.208
Cost
6.00%
13.00%
17.00%
WeightedCost
4.704%
0.104%
3.536%
8.344%
b. Marketvalueweights:
TypeofCapital
LTdebt
Preferredstock
Commonstock
c.
MarketValue
$3,840,000
60,000
3,000,000
$6,900,000
Weight
0.557
0.009
0.435
Cost
6.00%
13.00%
17.00%
WeightedCost
3.342%
0.117%
7.395%
10.854%
Thedifferenceliesinthetwodifferentvaluebases.Themarketvalueapproachyieldsthe
bettervaluesincethecostsofthecomponentsofthecapitalstructurearecalculatedusingthe
prevailingmarketprices.Sincethecommonstockissellingatahighervaluethanitsbook
value,thecostofcapitalismuchhigherwhenusingthemarketvalueweights.Noticethatthe
bookvalueweightsgivethefirmamuchgreaterleveragepositionthanwhenthemarket
valueweightsareused.
P915. WACCandtargetweights
LG6;Intermediate
a.
Historicalmarketweights:
TypeofCapital
LTdebt
Preferredstock
Commonstock
b.
Cost
7.20%
13.50%
16.00%
WeightedCost
1.80%
1.35%
10.40%
13.55%
Weight
0.30
0.15
0.55
Cost
7.20%
13.50%
16.00%
WeightedCost
2.160%
2.025%
8.800%
12.985%
Targetmarketweights:
TypeofCapital
LTdebt
Preferredstock
Commonstock
c.
Weight
0.25
0.10
0.65
Usingthehistoricalweightsthefirmhasahighercostofcapitalduetotheweightingofthe
moreexpensivecommonstockcomponent(0.65)versusthetargetweightof(0.55).This
overweightingincommonstockleadstoasmallerproportionoffinancingcomingfromthe
significantlylessexpensivelongtermdebtandthelowercostingpreferredstock.
P916. Costofcapital
LG3,4,5,6;Challenge
a.
Costofretainedearnings
rr
$1.26(1 0.06)
$1.34
0.06
3.35% 6% 9.35%
$40.00
$40.00
b.
Costofnewcommonstock
rs
c.
$1.26(1 0.06)
$1.34
0.06
4.06% 6% 10.06%
$40.00 $7.00
$33.00
Costofpreferredstock
rp
rd
$2.00
$2.00
9.09%
$25.00 $3.00 $22.00
$1,000 $1,175
$65.00
5
5.98%
$1,175 $1,000
$1,087.50
2
$100
d.
ri5.98%(10.40)3.59%
e.
WACC(0.40)(3.59%)(0.10)(9.09%)(0.50)(9.35%)
WACC1.4360.9094.675
WACC7.02%
P917. Calculationofindividualcosts,WACC,andWMCC
LG3,4,5,6;Challenge
a.
Aftertaxcostofdebt
ApproximateApproach
rd
rd
($1,000 N d )
n
( N d $1,000)
2
($1,000 $950)
$100 $5
10
10.77%
($950 $1,000)
$975
2
$100
ri10.77(l0.40)
ri6.46%
Calculatorapproach
N10,PV$950,PMT$100,FV$1,000
SolveforI:10.84%
Aftertaxcostofdebt:10.84(10.40)6.51%
rp
b.
Dp
Np
Costofpreferredstock:
rp
$8
12.70%
$63
c.
Costofnewcommonstockequity:
Solveforg:
N4,PV$2.85,FV$3.75
SolveforI:7.10%
NetProceeds:CurrentpricePriceadjustmentFloatationcost
$50$5$3$42
rn$4.00$42.000.07100.09520.07100.1662$16.62%
d.
WACC:
2.60%
LTdebt
0.406.51%
Preferredstock
0.1012.70% 1.27%
Commonstock
0.5016.62% 8.31%
12.18%
WACC
P918. Weightedaveragecostofcapital
LG6;Intermediate
Rate
[1]
OutstandingLoanBalance
[2]
Weight
WACC
[2]64,000[3]
[1][3]
Loan1
6.00%
$20,000
31.25%
1.88%
Loan2
9.00%
$12,000
18.75%
1.69%
Loan3
Total
5.00%
$32,000
$64,000
50.00%
2.50%
6.06%
JohnDoughshouldnotconsolidatehiscollegeloansbecausetheirweightedcostislessthanthe
7.2%offeredbyhisbank.
P919. CalculationofindividualcostsandWACC
LG3,4,5,6;Challenge
a.
Aftertaxcostofdebt
Approximateapproach
rd
rd
($1,000 N d )
n
( N d $1,000)
2
($1,000 $940)
$80 $3
20
8.56%
($940 $1,000)
$970
2
$80
rird(1t)
ri8.56%(10.40)
ri5.14%
Calculatorapproach
N20,PV$940,PMT$80,FV$1,000
SolveforI:8.64%
Aftertaxcostofdebt:8.64%(10.40)5.18%
b. Preferredstock:
rp
rp
c.
Dp
Np
$7.60
8.44%
$90
Retainedearnings:
D1
g
P0
=($7.00$90)+0.06=0.0778+0.0600=0.1378or13.78%
rr
Newcommonstock:
D1
g
Nn
=[$7.00($90 $7 $5)]+0.06
=[$7.00$78]+0.06=0.0897+0.0600=0.1497or14.97%
rn
2.
3.
TypeofCapital
Withretainedearnings
Longtermdebt
Preferredstock
Commonstockequity
Withnewcommonstock
Longtermdebt
Preferredstock
Commonstockequity
Target
Capital
Structure%
Costof
Capital
Source
Weighted
Cost
0.30
0.20
0.50
5.18%
1.55%
8.44%
1.69%
13.78%
6.89%
WACC10.13%
0.30
0.20
0.50
5.18%
1.55%
8.44%
1.69%
14.97%
7.48%
WACC10.72%
P920. Weightedaveragecostofcapital
LG6;Intermediate
a.
WACC0.50(0.06)0.50(0.12)0.030.060.09or9.0%
b. WACC0.70(0.06)0.30(0.12)0.0420.0360.078or7.8%
c.
Theyareaffected,becauseundertherevisedcapitalstructurethereismoredebtfinancing.
Bondholdersrepresentaprior,legalclaimtothefirmsoperatingincome.Alargerinterest
expensemustbepaidpriortoanydividendpayment.Thereisalsoagreaterchanceof
bankruptcy,becausethefirmsoperatingincomemaybeinsufficientlylargetoaccommodate
thelargerinterestexpense.
d. WACC0.70(0.06)0.30(0.16)0.0420.0480.09,or9%
e.
Increasingthepercentageofdebtfinancingincreasestheriskofthecompanynotbeingableto
makeitsinterestpayments.Bankruptcywouldhavenegativeconsequencestobothbondholders
andstockholders.Asshowninpartd,ifstockholdersincreasetheirrequiredrateofreturn,the
costofcapitalmaynotdecline.Infact,ifthebondholdersrequiredahigherreturnalso,thecost
ofcapitalwouldactuallyriseinthisscenario.
P921. Ethicsproblem
LG1;Intermediate
GEslongstringofgoodearningsreportsmadethecompanyseemlessrisky,soit'scostofcapital
wouldbelower(e.g.,theAAAcreditratingmentionedinthechapteropenerisevidenceof
this).IfinvestorslearnthatGEisreallymoreriskythanitseems,thenthecostofcapitalwillgo
upandGE'svaluewillfall.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Making Star Products Financing/Investment Decision

TheChapter9case,StarProducts,isanexerciseinevaluatingthecostofcapitalandavailableinvestment
opportunities.Thestudentmustcalculatethecomponentcostsoffinancing,longtermdebt,preferred
stock,andcommonstockequity;determinethebreakpointsassociatedwitheachsource;andcalculatethe
WACC.Finally,thestudentmustdecidewhichinvestmentstorecommendtoStarProducts.
a.
Costoffinancingsources
Debt:
(1)Below$450,000:
CalculatorMethod:
N15,PV$960,PMT$90,FV$1,000
SolveforI9.51%
rird(1t)
ri9.51(10.4)
ri5.71%
ApproximationMethod:
rd
($1,000 Nd )
n
( Nd $1,000)
2
($1,000 $960)
15
rd
($960 $1,000)
2
$92.67
rd
0.0946 9.46%
$980
$90
rird(1t)
ri9.46(10.4)
ri5.68%
(2)Above$450,000: rird(1t)
ri13.0(10.4)
ri7.8%
(3)Preferredstock:
Dp
Np
rp
rp
$9.80
0.1508 15.08%
$65
Commonstockequity:
(4)$0$1,500,000:
rr
Di
g
P0
rr
$0.96
0.11 19%
$12
(5)Above$1,500,000:
b.
rr
Di
g
Nn
rr
$0.96
0.11 21.67%
$9
Weightedaveragecostofcapital:
1.
Target
Costof
Capital
Capital
Weighted
TypeofCapital
Structure%
Source
Cost
Longtermdebtlessthan$450,001andcommonequitylessthan$500,001:
Longtermdebt
0.30
5.7%
1.71%
Preferredstock
0.10
15.1%
1.51%
Commonstockequity
0.60
19.0%
11.40%
1.00
2.
WACC14.62%
Longtermdebtgreaterthan$450,000andcommonequitylessthan$1,500,00:
Longtermdebt
0.30
7.8%
2.34%
Preferredstock
0.10
15.1%
1.51%
Commonstockequity
0.60
19.0%
11.40%
1.00
3.
WACC15.25%
Longtermdebtgreaterthan$450,000andcommonequityover$1,500,000:
Longtermdebt
0.30
7.8%
2.34%
Preferredstock
0.10
15.1%
1.51%
Commonstockequity
0.60
21.7%
13.02%
1.00
WACC16.87%
c.
Breakpoints
AF
W
$450,000
$1,500,000
0.30
$1,500,000
$2,500,000
0.60
Breakpoint
(1)BPLongtermdebt
(2)BPcommonequity
(3) Basedontheinformationabove,cheaperdebtfinancingisexhaustedwhenthevalue
ofprojectsacceptedexceeds$1,500,000.Retainedearningscanfinance$2,500,000of
newprojectswithouthavingtoissueadditionaldebt.Inthepriorcalculationofweighted
averagecostsofcapital,aweightedaveragecostsofcapitalforcheapdebtandexternal
equityfinancingwasnotneededbecauseStarProductsrunsoutoffinancingfromcheap
debtfirst.
d.
Investmentrankingsarerankedintermsoftheirrateofreturn.Theprojectwiththehighestrateof
returnisProjectC,whichyields25%.ProjectGs14%rateofreturnistheworst.Thefollowing
diagramdepictstherankingofprojectsandincludestheweightedmarginalcostsofcapital.The
jumpsintheWMCCoccuratbreakpointswhereacheapersourceoffinancingisexhausted.
e.
(1)Cheapdebtandequity
ThefirstbreakpointexistswhenStarProductshasusedall$450,000in9%debt.Assumingthata
morecostlysourceofdebtfinancingisnotavailable,thefirmwouldacceptprojectsC,D,andB.
(2)Cheapdebtandhalfasmuchretainedearnings
IfStarProductsonlyhad$750,000incommonstockequityavailable,itsequitybreakpointwouldbe
$1,250,000($750,0000.6).ThisamountisstillsufficienttofinancingProjectsC,D,andB;which
combinedhaveacostof$1,300,000.
(3)Cheapdebtandall$1,500,000ofretainedearnings(illustratedinPartd)
IfStarProductscanacquire$1,500,000incommonequity,itcanfinance$2,500,000ofnewprojects.
ThisallowsittoaddProjectsF,andE.ThereturnonProjectsAandGisnotsufficienttoallow
acceptanceoftheseprojects.
(4)Limitedtotaldebtand$1,500,000ofretainedearnings
IfStarProductsislimitedbyaccesstoonlya$1,000,000oflongtermdebt,itsbreakpointwouldbe
$3,333,333($1,000,0000.3).Theonemilliondollaramountwouldbesufficienttofinanceall
projects,whichintotalcost$3,300,000,iftheirreturnsweresufficient.Asstatedabove,thereturns
onprojectAandGarelessthantheweightedmarginalcostofcapitalandwillberejected.
Spreadsheet Exercise
TheanswertoChapter9smeasurementofthecostofcapitalatNovaCorporationspreadsheetproblemis
locatedontheInstructorsResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Accuratelymeasuringthecostofcapitalisthetopicofthischapter.Thegroupexercisewillusecurrent
informationfromtheshadowfirmtoprovidedetailsforeachgroupsfictitiousfirm.Thebalancesheetis
thesourceofthisinformationandtheassignmentbeginswithaninvestigationintotheshadowfirms
debt/equitymix.
Thegroupusestheshadowfirmsbalancesheetasaguidetodevelopingabalancesheetfortheirfictitious
firm.Studentsshouldcloselyfollowthesourcesandusesoftheshadowfirmsfinancing.Usingthisbalance
sheettheWACCisthenestimated.Finally,thegroupidentifiesanewproject,identifiesitsIRR,and
comparesittotheestimatedWACCinordertodeterminewhetherthenewprojectshouldbeaccepted.
Onealternativeisfortheinstructortoidentifyaseriesofprojectsandtheircashflows,requiringstudents
todeterminetheacceptabilityofeachgiventheestimatedWACC.
Integrative Case 4: Eco Plastics Company

Thiscasefocusesondeterminationofthecostofcapitalforafirm.Thestudentdeterminesthecostof
individualsourcesoffinancing,includinglongtermdebt,preferredstock,andcommonstock.Thecostof
debtisadjustedforEcoPlastics40%taxbracket.Thecompanyisconsideringanewfinancialstructure,
withthereplacementofpreferredstockfinancingwithdebtfinancing.Additionaluseofdebtincreasesthe
commonstockholdersrequiredrateofreturn.Thestudentisaskedtocomparethetwoweightedaverage
costsofcapitalandidentifythebetterfinancialstructureforEcoPlasticsCompany.
a.
Costofdebt:
Proceedsfromsaleof$1,000parvaluebond:
$1,000(averagediscount&floatationcosts)
$1,000($45$32)$923
Subsequentpayments:Interestpayments($1,0000.105)Parvalue
Beforetaxcostofdebt
N20,PV$923,PMT105,FV1,000
SolveforI11.50%
Aftertaxcostofdebt:rird(1T)
11.5%(10.4)6.9%
b.
Costofpreferredstock:
rpDpNp
(0.095$95)($95$7)
$9.02$88
10.25%
c.
Costofcommonstock:
rjRF[bj(rmRF)]
0.04[1.3(0.130.04)]
0.04[1.30.09]
0.040.1170
15.7%
d.
Weightedaveragecostofcapital: ra(wiri)(wprp)(wsrn)
(0.300.069)(0.200.1025)(0.500.157)
0.02070.02050.785
0.1197,orabout12%
e.
1. ChangeinriskPremium:
Changeinbetamarketriskpremium
(1.51.3)(0.130.04)
0.20.090.018
Shareholdersrequire1.8%moreperyear
Newcostofcommonequity: rjRF[bj(rmRF)]
0.04[1.5(0.130.04)]
0.04[1.50.09]
0.040.1350
17.5%
Note: 17.5%15.7%1.8%
2. Revisedweightedaveragecostofcapital:ra(wixri)(wsxrn)
(0.500.069)(0.500.175)
0.03450.0875
0.1220
3. EcoPlasticsCFOshouldretainthecheapercurrentfinancialstructure.Replacingpreferredstock
financingwithdebtfinancingresultsinmorerisktothestockholders.Theincreaseinstockholders
requiredrateofreturnmorethanoffsetstheadvantageofusingthelowcostdebt.IfEcoPlastics
CFOweretorevisethecapitalstructure,sharepricewouldfallandshareholderwealthwouldnot
bemaximized.

Chapter 09

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 09

Uploaded by

Copyright:

Available Formats

Chapter9

Suggested Answers to Opener in Review Questions

Answers to Review Questions

Suggested Answer to Focus on Practice Box: Uncertain Times Make

Suggested Answer to Focus on Ethics Box: The Ethics of Profit

Answers to Warm-Up Exercises

Making Star Products Financing/Investment Decision

Integrative Case 4: Eco Plastics Company

You might also like