Chapter 11

Discussion Questions
11-1. Why do we use the overall cost of capital for investment decisions even when
only one source of capital will be used (e.g., debt)?
Though an investment nanced by low-cost debt might appear acceptable at
rst glance, the use of debt could increase the overall ris! of the rm and
eventually ma!e all forms of nancing more e"pensive. #ach pro$ect must be
measured against the overall cost of funds to the rm.
11-%. &ow does the cost of a source of capital relate to the valuation concepts
presented previously in 'hapter 1(?
The cost of a source of nancing directly relates to the re)uired rate of return
for that means of nancing. *f course, the re)uired rate of return is used to
establish valuation.
11-+. ,n computing the cost of capital, do we use the historical costs of e"isting
debt and e)uity or the current costs as determined in the mar!et? Why?
,n computing the cost of capital, we use the current costs for the various
sources of nancing rather than the historical costs. We must consider what
these funds will cost us to nance pro$ects in the future rather than their past
costs.
11--. Why is the cost of debt less than the cost of preferred stoc! if both securities
are priced to yield 1( percent in the mar!et?
#ven though debt and preferred stoc! may be both priced to yield 1( percent
in the mar!et, the cost of debt is less because the interest on debt is a ta"-
deductible e"pense. . 1( percent mar!et rate of interest on debt will only
cost a rm in a
+/ percent ta" brac!et an afterta" rate of 0./ percent. The answer is the
yield multiplied by the di1erence of (one minus the ta" rate).
11-/. What are the two sources of e)uity (ownership) capital for the rm?
The two sources of e)uity capital are retained earnings and new common
stoc!.
11-0. #"plain why retained earnings have an opportunity cost
associated?
2etained earnings belong to the e"isting common stoc!holders. ,f
the funds are paid out instead of reinvested, the stoc!holders
could earn a return on them. Thus, we say retaining funds for
reinvestment carries an opportunity cost.
11-3. Why is the cost of retained earnings the e)uivalent of the rm4s
S11-1
own re)uired rate of return on common stoc! (5e)?
6ecause stoc!holders can earn a return at least e)ual to their
present investment. 7or this reason, the rm4s rate of return (5e)
serves as a means of appro"imating the opportunities for
alternate investments.
11-8. Why is the cost of issuing new common stoc! (5n) higher than the
cost of retained earnings (5e)?
,n issuing new common stoc!, we must earn a slightly higher
return than the normal cost of common e)uity in order to cover
the distribution costs of the new security. ,n the case of the 6a!er
'orporation, the cost of new common stoc! was si" percent
higher.
11-9. &ow are the weights determined to arrive at the optimal
weighted average cost of capital?
The weights are determined by e"amining di1erent capital
structures and using that mi" which gives the minimum cost of
capital. We must solve a multidimensional problem to determine
the proper weights.
11-1(. #"plain the traditional, :-shaped approach to the cost of capital.
The logic of the :-shaped approach to cost of capital can be
e"plained through 7igure 11-1. ,t is assumed that as we initially
increase the
debt-to-e)uity mi" the cost of capital will go down. .fter we
reach an optimum point, the increased use of debt will increase
the overall cost of nancing to the rm. Thus we say the
weighted average cost of capital curve is :-shaped.
11-11. ,t has often been said that if the company can4t earn a rate of
return greater than the cost of capital it should not ma!e
investments. #"plain.
,f the rm cannot earn the overall cost of nancing on a given
pro$ect, the investment will have a negative impact on the rm4s
operations and will lower the overall wealth of the shareholders.
'learly, it is undesirable to invest in a pro$ect yielding 8 percent
if the nancing cost is 1( percent.
11-1%. What e1ect would in;ation have on a company4s cost of capital?
(&int< Thin! about how in;ation in;uences interest rates, stoc!
prices, corporate prots, and growth.)
,n;ation can only have a negative impact on a rm4s cost of
capital-forcing it to go up. This is true because in;ation tends to
S11-2
increase interest rates and lower stoc! prices, thus raising the
cost of debt and e)uity directly and the cost of preferred stoc!
indirectly.
11-1+. What is the concept of marginal cost of capital?
The marginal cost of capital is the cost of incremental funds.
.fter a rm reaches a given level of nancing, capital costs will
go up because the rm must tap more e"pensive sources. 7or
e"ample, new common stoc! may be needed to replace retained
earnings as a source of e)uity capital.
Appendix A
Discussion Questions
11.-1. &ow does the capital asset pricing model help e"plain changing costs
of capital?
The capital asset pricing model e"plains the relationship between
ris! and return, and the price ad$ustment of capital assets to changes
in ris! and return. .s investors react to their economic environment
and their willingness to ta!e ris!, they change the prices of nancial
assets li!e common stoc!, bonds, and preferred stoc!. .s the prices
of these securities ad$ust to investors4 re)uired returns, the
company4s cost of capital is ad$usted accordingly.
11.-%. &ow does the =>? react to changes in the rate of interest, changes in
the rate of in;ation, and changing investor e"pectations?
The =>?, =ecurity >ar!et ?ine, re;ects the ris!-return tradeo1s of
securities. .s interest rates increase, the =>? moves up parallel to
the old =>?. @ow investors re)uire a higher minimum return on ris!
free assets and an e)ually higher rate for all levels of ris!. . change
in the rate of in;ation has a similar impact. The ris! free rate goes up
to provide the appropriate in;ation premium and there is an upward
shift in the =>?.
,n regard to changing investor e"pectations, as investors become
more ris! averse, the =>? increases its slope. The more ris! ta!en,
the greater the return premium that is desired (see gure 11.--).
Problems
1. 2ambo #"terminator 'ompany bought a A6ug #radicatorB in .pril of %((8 that
provided
a return of 3 percent. ,t was nanced by debt costing 0 percent. ,n .ugust, >r.
2ambo came up with an Aentire bug colony destroyingB device that had a return of
1% percent.
The 'hief 7inancial *Ccer, >r. 2oach, told him it was impractical because it would
S11-3
re)uire the issuance of common stoc! at a cost of 1+./ percent to nance the
purchase.
,s the company following a logical approach to using its cost of capital?
11-1. Solution:
Rambo Exterminator Company
@o, each individual pro$ect should not be measured against the specic means of
nancing that pro$ect, but rather against the weighted average cost of nancing all
pro$ects for the rm. This principle recogniDes that the availability of one source of
nancing is dependent on other sources. *nce a common overall cost is
determined, the Ecolony destroying deviceF yielding 1% percent is much more li!ely
to be accepted than the Ebug eradicatorF only yielding 3 percent.
S11-4
%. 2oyal Getroleum 'o. can buy a piece of e)uipment that is anticipated to provide a 9
percent return and can be nanced at 0 percent with debt. ?ater in the year, the
rm turns down
an opportunity to buy a new machine that would yield a 10 percent return but would
cost
18 percent to nance through common e)uity. .ssume debt and common e)uity
each represent /( percent of the rmFs capital structure.
a. 'ompute the weighted average cost of capital.
b. Which pro$ect(s) should be accepted?
11-. Solution:
Royal Petroleum Co.
Weighted
a. 'ost Weights 'ost
Hebt 0I /(I +I
'ommon e)uity 18I /(I 9I
Weighted average cost of capital 1%I
b. *nly the new machine with a return of 10 percent.
The return e"ceeds the weighted average cost of capital of 11.(
percent.
+. =ullivan 'ement 'ompany can issue debt yielding 1+ percent. The company is
paying a
+0 percent rate. What is the afterta" cost of debt?
11-!. Solution:
Sulli"an Cement Company
5d J Kield (1 L T)
J 1+I (1 L .+0)
J 1+I (.0-)
J 8.+%I
-. 'alculate the afterta" cost of debt under each of the following conditions.
#ield Corporate $ax
Rate
a. 8.(I 18I
b. 1%.(I +-I
c. 1(.0I 1/I
11-%. Solution:
5d J Kield (1 L T)
S11-5
#ield &1 ' $( #ield &1 ' $(
a. 8.(I (1 L .18) 0./0I
b. 1%.(I (1 L .+-) 3.9%I
c. 1(.0I (1 L .1/) 9.(1I
/. Calculate the aftertax cost of debt under each of the following conditions.
#ield Corporate $ax
Rate
a. 9.(I %/I
b. 1(.0 +/
c. 8./ (
11-). Solution:
5d J Kield (1 L T)
#ield &1 ' $( #ield&1 ' $(
a. 9.(I (1 L .%/) 0.3/I
b. 1(.0I (1 L .+/) 0.89I
c. 8./I (1 L () 8./(I
0. The >illennium 'haritable 7oundation, which is ta"-e"empt, issued debt last year at
8 percent to help nance a new playground facility in 'hicago. This year the cost of
debt
is 1/ percent higherM that is, rms that paid 1( percent for debt last year would be
paying 11./ percent this year.
a. ,f the >illennium 'haritable 7oundation borrowed money this year, what would
the after ta" cost of debt be, based on its cost last year and the 1/ percent
increase?
b. ,f the 7oundation was found to be ta"able by the ,2= (at a rate of +/ percent)
because it was involved in political activities, what would the afterta" cost of
debt be?
11-*. Solution:
+illennium Charitable ,oundation
a. 5d J Kield (1 L T)
Kield J 8I N 1.1/ J 9.%(I
5d J 9.%I (1 L () J 9.%I (1) J 9.%I
b. 5d J 9.%I (1 L .+/) J 9.%I (.0/) J /.98I
3. :seless Tool 'o. ,nc., has an afterta" cost of debt of 0 percent. With a ta" rate of
++ percent, what can you assume the yield on the debt is?
S11-6
11--. Solution:
.seless tool co.
( )
( )
( )
d
d
K Yield 1
K
Yield !
1
6" 6"
Yield ! #.$5"
1 .33 .6%
=

= =

9I is an acceptable answer.
8. .ddison Olass 'ompany has a P1,((( par value bond outstanding with %/ years to
maturity. The bond carries an annual interest payment of P88 and is currently selling
for P9%/. .ddison is in a %/ percent ta" brac!et. The rm wishes to !now what the
afterta" cost of a new bond issue is li!ely to be. The yield to maturity on the new
issue will be
the same as the yield to maturity on the old issue because the ris! and maturity
date will
be similar.
a. 'ompute the appro"imate yield to maturity (7ormula 11-1) on the old issue and
use this as the yield for the new issue.
b. >a!e the appropriate ta" ad$ustment to determine the afterta" cost of debt.
11-/. Solution:
Addison 0lass Company
a.
&a'(ent) *+rinci&al .4 bond) of *+rice .6
(aturit' to 'ears of ,u(ber
bond the of +rice &a'(ent +rinci&al
&a'(ent interest -nnual
Y.
+

+
=
( ) ( )
/10 111 /$25
/##
25
.6 /$25 .4 /10 111

+
=
+
/%5
/##
25
/555 /411
+
=
+
/## /3
/$55
+
=
S11-%
/$1
$.53"
/$55
= =
b. 5d J Kield (1 L T)
J 9./+I (1 L .%/)
J 9./+I (.3/)
J 3.1/I
9. &ewlett =oftware 'orporation has a P1,((( par value bond outstanding with %(
years to maturity. The bond carries an annual interest payment of P11( and is currently
selling for P1,(8( per bond. &ewlett is in a +/ percent ta" brac!et. The rm wishes to
!now what the afterta" cost of a new bond issue is li!ely to be. The yield to maturity on
the new issue
will be the same as the yield to maturity on the old issue because the ris! and maturity
date will be similar.
a. 'ompute the appro"imate yield to maturity (7ormula 11-1) on the old issue and
use this as the yield for the new issue.
b. >a!e the appropriate ta" ad$ustment to determine the afterta" cost of debt.
11-1. Solution:
2e3lett So4t3are Corporation
a.
&a'(ent) *+rinci&al .4 bond) of *+rice .6
(aturit' to 'ears of ,u(ber
bond the of +rice &a'(ent +rinci&al
&a'(ent interest -nnual
Y.
+

+
=
( ) ( )
/10 111 /10 1#1
/111
21
.6 /10 1#1 .4 /10 111

+
=
+
/#1
/111
21
/64# /411

+
=
+
/111 /4
/10 14#

=
/116
11.11"
/10 14#
= =
S11-#
b. 5d J Kield (1 L T)
J 1(.11I (1 L .+/)
J 1(.11I (.0/)
J 0./3I
S11-$
1(. 7or &ewlett =oftware 'orporation described in problem 9, assume that the yield on
the bonds goes up by 1 percentage point and that the ta" rate is now -/ percent.
a. What is the new afterta" cost of debt?
b. &as the afterta" cost of debt gone up or down from problem 9? #"plain why.
11-15. Solution:
2e3lett So4t3are Corporation &Continued(
a. 5d J Kield (1 L T)
J 1%.((I (1 L .-/)
J 1%.((I (.//)
J 0.0(I
b. The cost has gone up. The increased yield had a greater impact than the
changed ta" rate.
11. >cHonaldFs 'orporation is planning to issue debt that will mature in %(%8. ,n many
respects the issue is similar to currently outstanding debt of the corporation. :sing
Table 11-% of the chapter,
a. ,dentify the yield to maturity on similarly outstanding debt for the rm, in terms
of maturity.
b. .ssume that because the new debt will be issued at par, the re)uired yield to
maturity will be (.%( percent higher than the value determined in part a. .dd
this factor to the answer in a. (@ew issues at par sometimes re)uire a slightly
higher yield than old issues that are trading below par. There is less leverage
and fewer ta" advantages.)
c. ,f the rm is in a +( percent ta" brac!et, what is the afterta" cost of debt?
11-11. Solution:
+c Donald6s Corporation
a. /.8(I
b. /.8(I Q .%(I J 0.((I
c. 5d J Kield (1 L T)
J 0.((I (1 L .+()
J 0.((I (.3()
J -.%(I
1%. 6urger Rueen can sell preferred stoc! for P3( with an estimated ;otation cost of
P%./(.
,t is anticipated the preferred stoc! will pay P0 per share in dividends.
a. 'ompute the cost of preferred stoc! for 6urger Rueen.
b. Ho we need to ma!e a ta" ad$ustment for the issuing rm?
11-1. Solution:
7ur8er Queen
S11-11
a.
&
&
&
2
K
+ 3
/6.11 /6.11
#.#$"
/%1.11 /2.51 /6%.51
=

= = =

b. @o ta" ad$ustment is re)uired. Greferred stoc! dividends are not a ta"

deductible e"pense for the issuing rm (the dividends, of course, are 3(
percent ta" e"empt to a corporate recipient).
1+. Wallace 'ontainer 'ompany issued P1(( par value preferred stoc! 1% years ago.
The stoc! provided a 9 percent yield at the time of issue. The preferred stoc! is now
selling for P3%. What is the current yield or cost of the preferred stoc!? (Hisregard
;otation costs.)
11-1!. Solution:
9allace Container Company
&
&
2
/$
Yield ! 12.5"
2 /%2
= =
1-. The treasurer of 6io=cience, ,nc., is as!ed to compute the cost of "ed income
securities for her corporation. #ven before ma!ing the calculations, she assumes the
afterta" cost of debt is at least % percent less than that for preferred stoc!. 6ased on the
following facts, is she correct?
Hebt can be issued at a yield of 11 percent, and the corporate ta" rate is +(
percent. Greferred stoc! will be priced at P/( and pays a dividend of P-.8(. The
;otation cost on
the preferred stoc! is P%.1(.
11-1%. Solution:
7io Science: ;nc.
.fterta" cost of debt
d
K Yield *1 )
!11"*1 .31) ! 11" *.%1) ! %.%1"
=

.fterta" cost of Greferred stoc!

S11-11
&
&
&
2
K
+ 3
/4.#1 /4.#1
11.12"
/51 /2.11 /4%.$1
=

= = =

Kes, the treasurer is correct. The di1erence is %.+%I

(3.3(I versus 1(.(%I).
1/. >urray >otor 'ompany wants you to calculate its cost of common stoc!. Huring the
ne"t 1% months, the company e"pects to pay dividends (H1) of P%./( per share, and
the current price of its common stoc! is P/( per share. The e"pected growth rate is
8 percent.
a. 'ompute the cost of retained earnings (5e). :se 7ormula 11-0.
b. ,f a P+ ;otation cost is involved, compute the cost of new common stoc! (5n).
:se 7ormula 11-3.
.
11-1). Solution:
+urray +otor Co.
a.
1
e
1
2
K g
+
/2.51
! #" 5" #" 13"
/51
= +
+ = + =
b.
1
n
1
2
K g
+ 3
/2.51 /2.51
! #" #"
/51 /3 /4%
5.32" #" 13.32"
= +

+ = +

= + =
10. 'ompute 5e and 5n under the following circumstances<
a. H1 J P-.%(, G( J P//, g J /I, 7 J P+.8(.
b. H1 J P(.-(, G( J P1/, g J 8I, 7 J P1.
c. #1 (earnings at the end of period one) J P8, payout ratio e)uals %/ percent,
G( J P+%, g J /I, 7 J P%.
d. H( (dividend at the beginning of the rst period) J P+, growth rate for dividends
and earnings (g) J 9I, G( J P0(, 7 J P+./(.
11-1*. Solution:
S11-12
a.
1
e
1
1
n
1
2
K g
+
/4.21
! 5" %.64" 5" 12.64"
/55
2
K g
+ 3
/4.21 /4.21
! 5" 5"
/55 /3.#1 /51.21
#.21" 5" 13.21"
= +
+ = + =
= +

+ = +

= + =
b.
1
e
1
1
n
1
2
K g
+
/1.41
! #" 2.66" #" 11.66"
/15
2
K g
+ 3
/.41
! #"
/15 /1
/.41
#" 2.#6" #" 11.#6"
/14
= +
+ = + =
= +

= + = + =
11-1*. &Continued(
c.
1 1
25" 4 25" /#.11 /2.11 D = = =
S11-13
1
e
1
1
n
1
2
K g
+
/2.11
! 5" 6.25" 5" 11.25"
/32
2
K g
+ 3
/2.11
! 5"
/32 /2
/2.11
5" 6.6%" 5" 11.6%"
/31
= +
+ = + =
= +

= + = + =
d.
1 1
1
e
1
1
n
1
2 2 *1 g) /3.11 *1.1$) /3.2%
2
K g
+
/3.2%
$" 5.45" $" 14.45"
/61
2
K g
+ 3
/3.2%
$"
/61 /3.51
/3.2%
$" 5.%$" $" 14.%$"
/56.61
= + = =
= +
= + = + =
= +

= +

= + = + =
13. 6usiness has been good for 5eystone 'ontrol =ystems, as indicated by the four-year
growth in earnings per share. The earnings have grown from P1.(( to P1.0+.
a. :se .ppendi" . at the bac! of the te"t to determine the compound annual rate
of growth in earnings (n J -).
b. 6ased on the growth rate determined in part a, pro$ect earnings for ne"t year
(#1). 2ound to two places to the right of the decimal point.
c. .ssume the dividend payout ratio is -( percent. 'ompute H1. 2ound to two
places to the right of the decimal point.
d. The current price of the stoc! is P/(. :sing the growth rate (g) from part a and
(H1) from part c, compute 5e.
e. ,f the ;otation cost is P+.3/, compute the cost of new common stoc! (5n).
S11-14
11-1-. Solution:
<eystone Control Systems
a.
53
/1.63
36
1.11
=
7rom .ppendi" ., 7S,7 J 1.0+ for (n J -, i J 1+I).
b.
1 1
4 4 *1 g)
/1.63 *1.13)
/1.#4
= +
=
=
c.
1 1
2 4 41"
/1.#4 41"
/.%4
=
=
=
d.
1
e
o
2
K g
+
/.%4
13"
/51
1.4#" 13"
14.4#"
= +
= +
= +
=
11-1-. &Continued(
e.
1
n
o
2
K g
+ 3
/.%4
13"
/51 /3.%5
/.%4
13"
/46.25
1.6" 13" 14.61"
= +

= +

= +
= + =
18. Olobal TechnologyFs capital structure is as follows<
Hebt....................... +/I
S11-15
Greferred stoc!....... 1/
'ommon e)uity..... /(
The afterta" cost of debt is 0./ percentM the cost of preferred stoc! is 1( percentM
and the cost of common e)uity (in the form of retained earnings) is 1+./ percent.
'alculate Olobal TechnologyFs weighted average cost of capital in a manner
similar to Table 11-1.
11-1/. Solution:
0lobal $echnolo8y
Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
0./I
1(.(
1+./
+/I
1/
/(
%.%3I
1./(
0.3/
1(./%I
19. .s an alternative to the capital structure shown in problem 18 for Olobal Technology,
an outside consultant has suggested the following modications.
Hebt....................... 0(I
Greferred stoc!....... /
'ommon e)uity..... +/
:nder this new and more debt-oriented arrangement, the afterta" cost of debt is 8.8
percent, the cost of preferred stoc! is 11 percent, and the cost of common e)uity (in
the form of retained earnings) is 1/.0 percent.
2ecalculate OlobalFs weighted average cost of capital. Which plan is optimal in
terms of minimiDing the weighted average cost of capital?
11-11. Solution:
0lobal $echnolo8y &Continued(
Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
8.8I
11.(
1/.0
0(I
/
+/
/.%8I
(.//
/.-0
11.%9I
S11-16
The plan presented in Groblem 11-18 is the better alternative. #ven though the
second plan has more relatively cheap debt, the increased costs of all forms of
nancing more than o1set this factor.
%(. >ary *tt &otels wants to deter(ine the (ini(u( cost of ca&ital &oint for the fir(. -ssu(e it is
considering the following financial &lans7
Cost
&a4tertax(
9ei8h
ts
Plan A
Hebt................................. 0.(I %(I
Greferred stoc!................. 1(.( 1(
'ommon e)uity................ 1+.( 3(
Plan 7
Hebt................................. 0./I +(I
Greferred stoc!................. 1(./ 1(
'ommon e)uity................ 1+./ 0(
Plan C
Hebt................................. 3.(I -(I
Greferred stoc!................. 1(.3 1(
'ommon e)uity................ 1-.% /(
Plan D
Hebt................................. 9.(I /(I
Greferred stoc!................. 11.% 1(
'ommon e)uity................ 10.( -(
a. Which of the four plans has the lowest weighted average cost of capital? (2ound
to two places to the right of decimal point.)
b. 6rie;y discuss the results from Glan ' and Glan H, and why one is better than
the other.
11-5. Solution:
a. 'ost Weighted
(after ta") Weights 'ost
Glan .
Hebt 0.(I %(I 1.%(I
Greferred stoc! 1(.( 1( 1.((
'ommon e)uity 1+.( 3( 9.1(
11.+(I
Glan 6
Hebt 0./I +(I 1.9/I
Greferred stoc! 1(./ 1( 1.(/
'ommon e)uity 1+./ 0( 8.1(
11.1(I
Glan '
Hebt 3.(I -(I %.8(I
Greferred stoc! 1(.3 1( 1.(3
'ommon e)uity 1-.% /( 3.1(
S11-1%
1(.93I
Glan H
Hebt 9.(I /(I -./(I
Greferred stoc! 11.% 1( 1.1%
'ommon e)uity 10.( -( 0.-(
1%.(%I
Glan ' has the lowest weighted average cost of capital
b. Glan H is higher than Glan ' because all components in the capital structure
increased sharply after the rm hit the
/( percent debt level.
%1. Oiven the following information, calculate the weighted average cost of capital for
&amilton 'orp. ?ine up the calculations in the order shown in Table 11-1.
Percent o4 capital structure:
Hebt....................... +(I
Greferred stoc!....... 1/
'ommon e)uity..... //
Additional in4ormation:
6ond coupon rate....................... 1+I
6ond yield to maturity................ 11I
Hividend, e"pected common...... P+.((
Hividend, preferred.................... P1(.((
Grice, common............................ P/(.((
Grice, preferred........................... P98.((
7lotation cost, preferred............. P/./(
Orowth rate................................ 8I
'orporate ta" rate...................... +(I
S11-1#
11-1. Solution:
$he 2amilton Corp.
5d J Kield (1 L T)
J 11I (1 L (.+()
J 11I (.3()
J 3.3I
The bond yield of 11I is used rather than the coupon rate of 1+I because
bonds are priced in the mar!et according to competitive yields to maturity. The
new bond would be sold to re;ect yield to maturity.
&
&
&
1
e
1
2
K
+ 3
/11.11 /11.11
11.#1"
/$# /5.51 /$2.51
2
K g
+
/3
#" 6" #" 14"
/51
=

= = =

= +
= + = + =
Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
3.3(I
1(.81
1-.((
+(I
1/
//
%.+1I
1.0%
3.3(
11.0+I
%%. Oiven the following information, calculate the weighted average cost of capital for
Higital Grocessing, ,nc. ?ine up the calculations in the order shown in Table 11-1.
Percent o4 capital structure:
Greferred stoc!............ 1/I
'ommon e)uity.......... -(
Hebt............................ -/
Additional in4ormation:
S11-1$
'orporate ta" rate...................... +-I
Hividend, preferred.................... P8./(
Hividend e"pected, common...... P%./(
Grice, preferred........................... P1(/.((
Orowth rate................................ 3I
6ond yield.................................. 9./I
7lotation cost, preferred............. P+.0(
Grice, common............................ P3/.((
11-. Solution:
Di8ital Processin8: ;nc.
5d J Kield (1 L T)
J 9./I (1 L .+-)
J 9./I (.00)
J 0.%3
5p J HpT(Gp L 7)
J P8./(T(P1(/ L +.0() J P8./(TP1(1.-( J 8.+8I
5e J (H1TG() Q g
J (P%./(TP3/) Q 3I J +.++I Q 3I J 1(.++I
%+. 'arr .uto Garts is trying to calculate its cost of capital for use in a capital budgeting
decision. >r. &orn, the vice-president of nance, has given you the following
information and has as!ed you to compute the weighted average cost of capital.
The company currently has outstanding a bond with a 1% percent coupon rate
and a convertible bond with an 8.1 percent coupon rate. The rm has been informed
by its investment ban!er, ."le, Wiell, and ."le, that bonds of e)ual ris! and credit
rating are now selling to yield 1- percent. The common stoc! has a price of P+( and
an e"pected dividend (H1) of P 1.+( per share. The rmFs historical growth rate of
earnings and dividends per share has been 1/./ percent, but security analysts on
Wall =treet e"pect this growth to slow to 1% percent in the future. The preferred
stoc! is selling at P0( per share and carries a dividend of P0.8( per share. The
corporate ta" rate is +( percent. The ;otation costs are + percent of the selling price
for preferred stoc!.
The optimum capital structure for the rm seems to be -/ percent debt, /
percent preferred stoc!, and // percent common e)uity in the form of retained
earnings.
'ompute the cost of capital for the individual components in the capital
structure, and then calculate the weighted average cost of capital (similar to Table
11-1).
11-!. Solution:
Carr Auto Parts
5d J Kield (1 L T)
J 1-I (1 L .+() J 9.8(I
5p J HpT(Gp L 7)
S11-21
J P0.8(T(P0( L P1.8(U) J P0.8(TP/8.%( J 11.08I
U+I N P0( J P1.8(
5e J (H1TG() Q g
J (P1.+(TP+(.(() Q 1%I J -.++I Q 1%I J 10.++I
Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
9.8(I
11.08
10.++
-/I
/
/(
-.-1I
./8
8.13
1+.10I
%-. >c@abb 'onstruction 'ompany is trying to calculate its cost of capital for use in
ma!ing a capital budgeting decision. >r. 2eid, the vice- president of nance, has
given you the following information and has as!ed you to compute the weighted
average cost of capital.
The company currently has outstanding a bond with a 9./ percent coupon rate
and another bond with a 3.8 percent rate. The rm has been informed by its
investment ban!er that bonds of e)ual ris! and credit rating are now selling to yield
1(./ percent. The common stoc! has a price of P98.-- and an e"pected dividend
(H1) of P+.1/ per share.
The historical growth pattern (g) for dividends is as follows.
P%.((
%.%-
%./1
%.81
'ompute the historical growth rate, round it to the nearest whole number, and use it
for g.
The preferred stoc! is selling at P9( per share and pays a dividend of P8./( per
share. The corporate ta" rate is +( percent. The ;otation cost is % percent of the
selling price for preferred stoc!. The optimum capital structure for the rm is +(
percent debt, 1( percent preferred stoc!, and 0( percent common e)uity in the form
of retained earnings.
'ompute the cost of capital for the individual components in the capital
structure, and then calculate the weighted average cost of capital (similar to Table
11-1).
11-%. Solution:
+c=abb Construction Co.
5d J Kield (1 L T)
J 1(./I (1 L .+() J 1(./I (.3() J 3.+/I
5p J HpT(Gp L 7)
J P8./(T(P9( L P1.8() J P8./(TP88.%( J 9.0-I
5e J (H1TG() Q g
H1 J P+.1/
S11-21
G( J P98.--
g J 1%I (see below)
P%-T%.(( J 1%I
P%3T%.%- J 1%.(/I
P+(T%./1 J 11.9/I
2ound to 1%I or P%.81T%.(( J 1.-(/ nJ+, 7S,7 J 1.-(/ (.GG..)
g J 1%I
5e J (H1TG() Q g
J P+.1/TP98.-- Q 1%I J +.%(I Q 1%I J 1/.%(I
6ring the above values together to compute the weighted average cost of
capital
Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d).................................
Greferred stoc! (5p)................
'ommon e)uity (5e)
(retained earnings)...............
3.+/I
9.0-
1/.%(
+(I
1(I
0/I
%.%(/I
.90-
9.1%(
Weighted average cost
of capital (5a).......................
1%.%89I or
1%.%9I
%/. 7irst Tennessee :tility 'ompany faces increasing needs for capital. 7ortunately, it
has an .a% credit rating. The corporate ta" rate is +0 percent. 7irst TennesseeFs
treasurer is trying to determine the corporationFs current weighted average cost of
capital in order to assess the protability of capital budgeting pro$ects. &istorically
the corporationFs earnings and dividends per share have increased at about a 0
percent annual rate.
7irst TennesseeFs common stoc! is selling at P0( per share, and the company will
pay a P-.8( per share dividend (H1). The companyFs P1(( preferred stoc! has been
yielding
9 percent in the current mar!et. 7lotation costs for the company have been
estimated by its investment ban!er to be P1./( for preferred stoc!. The companyFs
optimum capital structure is -( percent debt, 1( percent preferred stoc!, and /(
percent common e)uity in the form of retained earnings. 2efer to the table below on
bond issues for comparative yields on bonds of e)ual ris! to 7irst Tennessee.
'ompute the answers to )uestions a, b, c, and d from the information given.
Data on 7ond ;ssues
;ssue
+oody6s
Ratin8 Price
#ield to
+aturity
.tilities:
6alt, OV# 88s %(1(................................. .a1 P 93/.%/ 8.0(I
@ew Kor! Tel. 'o. 3Ws %((9.................... .a% 8/(.3/ 9.11
>iss. Gow. 9.0%s %(11..............................1 90(./( 9.03
;ndustrials:
,6> 98s %(10.......................................... .aa P1,(/(./( 8./(I
>ay Hepartment =t. 3.9/s %(1(............. .a+ 9-(.(( 11.81
Oeneral >ills 98s %((9............................% 1,(+(.3/ 9.(/
S11-22
a. 'ost of debt, 5d (:se the table aboveXrelate to the utility bond credit rating for
yield.)
b. 'ost of preferred stoc!, 5p.
c. 'ost of common e)uity in the form of retained earnings, 5e.
d. Weighted average cost of capital.
S11-23
11-). Solution:
,irst $ennessee .tility Company
The student must realiDe that the cost of debt is related to the cost of debt for
other debt issues of the same ris! class. .lthough, in actuality, the rate 7irst
Tennessee might pay will not be e"actly e)ual to @ew Kor! Telephone 'ompany,
it should be close enough to serve as an appro"imation.
a. 5d J Kield (1 L T)
J 9.11I (1 L .+0) J 9.11I (.0-) J /.+8I
b. 5p J HpT(Gp L 7)
J P9.((T(P1(( L P1./() J P9.((TP98./( J 9.1-I
c. 5e J (H1TG() Q g
J (P-.8(TP0(.(() Q 0I J 8I Q 0I J 1-.((I
d. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d).....................................
Greferred stoc! (5p)....................
'ommon e)uity (5e)
(retained earnings)...................
Weighted average cost
of capital (5a)............................
/.8+I
9.1-
1-.((
-(I
1(
/(
%.++I
.91
3.((
1(.%-I
%0. 4aton 5nternational Cor&oration has the following ca&ital structure7
Cost
&a4terta
x(
9ei8h
ts
9ei8hted
Cost
Hebt (5d).................................................................... 3.1I %/I %.00I
Greferred stoc! (5p)................................................... 8.0 1( .80
'ommon e)uity (5e)
(retained earnings)................................................
1
-.1

0/ 9.1
3
Weighted average cost of capital (5a)....................... 1%.09I
a. ,f the rm has P19./ million in retained earnings, at what siDe capital structure
will the rm run out of retained earnings?
b. The 3.1 percent cost of debt referred to above applies only to the rst P1-
million of debt. .fter that the cost of debt will go up. .t what siDe capital
structure will there be a change in the cost of debt?
11-*. Solution:
Eaton ;nternational Corporation
S11-24
a.
9etained 4arnings
:
" of retained earnings in the ca&ital structure
/26(illion ; .65 /41(illion
=
= =
b.
-(ount of lower cost debt
<
" of debt in the ca&ital structure
/14 (illion ; .25 /56 (illion
=
= =
%3. The #vans 'orporation nds it is necessary to determine its marginal cost of capital.
#vansFs current capital structure calls for -/ percent debt, 1/ percent preferred
stoc!, and -( percent common e)uity. ,nitially, common e)uity will be in the form of
retained earnings (5e) and then new common stoc! (5n). The costs of the various
sources of nancing are as follows< debt, 0.% percentM preferred stoc!, 9.- percentM
retained earnings, 1%.( percentM and new common stoc!, 1+.- percent.
a. What is the initial weighted average cost of capital? (,nclude debt, preferred
stoc!,
and common e)uity in the form of retained earnings, 5e.)
b. ,f the rm has P%( million in retained earnings, at what siDe capital structure will
the rm run out of retained earnings?
c. What will the marginal cost of capital be immediately after that point? (#)uity
will remain at -( percent of the capital structure, but will all be in the form of
new common stoc!, 5n.)
d. The 0.% percent cost of debt referred to above applies only to the rst P+0
million of debt. .fter that the cost of debt will be 3.8 percent. .t what siDe
capital structure will there be a change in the cost of debt?
e. What will the marginal cost of capital be immediately after that point? ('onsider
the facts in both parts c and d.)
11--. Solution:
$he E"ans Corporation
a. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)..........................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
0.%I
9.-
1%.(
-/I
1/
-(
%.39I
1.-1
-.8(
9.((I
S11-25
9etained earnings
b. :
" of retained earnings within the ca&ital structure
/21 (illion
/51 (illion
.41
=
= =
S11-26
11--. &Continued(
c. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)..........................
Greferred stoc! (5p)..........
@ew common stoc!
(5n).................................
>arginal cost of capital
(5mc)...............................
0.%I
9.-
1+.-
-/I
1/
-(
%.39I
1.-1
/.+0
9./0I
-(ount of lower cost debt
d. <
" of debt within the ca&ital structure
/36 (illion
/#1 (illion
.41
=
= =
e. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
@ew common stoc!
(5n)......................................................
>arginal cost of capital
(5mc)....................................................
3.8I
9.-
1+.-
-/I
1/
-(
+./1I
1.-1
/.+0
1(.%8I
%8. The >cOee 'orporation nds it is necessary to determine its marginal cost of
capital. >cOeeFs current capital structure calls for -( percent debt, / percent preferred
stoc!, and // percent common e)uity. ,nitially, common e)uity will be in the form of
retained earnings (5e) and then new common stoc! (5n). The costs of the various sources
of nancing are as follows< debt, 3.- percentM preferred stoc!, 1(.( percentM retained
earnings, 1+.( percentM and new common stoc!, 1-.- percent.
a. What is the initial weighted average cost of capital? (,nclude debt, preferred
stoc!, and common e)uity in the form of retained earnings, 5e.)
b. ,f the rm has P%3./ million in retained earnings, at what siDe capital structure
will the rm run out of retained earnings?
c. What will the marginal cost of capital be immediately after that point? (#)uity
will remain at // percent of the capital structure, but will all be in the form of
new common stoc!, 5n.)
d. The 3.- percent cost of debt referred to above applies only to the rst P+%
million of debt. .fter that the cost of debt will be 8.0 percent. .t what siDe
capital structure will there be a change in the cost of debt?
e. What will the marginal cost of capital be immediately after that point? ('onsider
the facts in both parts c and d.)
11-/. Solution:
S11-2%
$he +c0ee Corporation
a. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)...............................................
Greferred stoc! (5p)...............................
'ommon e)uity (5e)
(retained earnings).............................
Weighted average cost
of capital (5a)......................................
3.-(I
1(.((
1+.((
-(I
/
//
%.90I
./(
3.1/
1(.01I
b.
9etained earnings
:
" of retained earnings within the ca&ital structure
/2%.5 (illion
/51 (illion
.55
=
= =
11-/. &Continued(
c. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)..........................
Greferred stoc! (5p)..........
@ew common stoc!
(5n).................................
>arginal cost of capital
(5mc)...............................
3.-(I
-(.((
1-.-(
-(I
/
//
%.90I
./(
3.9%
11.+8I
d.
-(ount of lower cost debt
<
" of debt within the ca&ital structure
/32 (illion
/#1 (illion
.41
=
= =
e. Cost
&a4tertax( 9ei8hts
9ei8hted
Cost
Hebt (5d)..........................
Greferred stoc! (5p)..........
@ew common stoc!
(5n).................................
>arginal cost of capital
(5mc)...............................
8.0(I
1(.((
1-.-(
-(I
/
//
+.--I
./(
3.9%
11.80I
S11-2#

S11-2$