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Chapter 11, Solutions Cornett, Adair, and Nofsinger

CHAPTER 11 CALCULATING THE COST OF CAPITAL


Questions
LG1 11-1 How would you handle calculating the cost of capital if a firm were planning two
issue two different classes of common stock?
Solution: As the two different classes of common stock are likely to have different component
costs, calculate the cost and weight for each separately.
LG2 11-2 hy don!t we multiply the cost of preferred stock "y 1 minus the ta# rate, as we do
for de"t?
Solution: Because dividends on preferred stock, unlike interest on debt, are paid out of after
ta! income.
LG2 11-$ %#pressing &CC in terms of i
"
, i
#
, and i
$
, what is the theoretical minimum for the
&CC?
Solution: %he theoretical minimum &ACC would be that for an alldebt firm: i
$
' ()%
C
*
LG$ 11-' (nder what situations would you want to use the C&)* approach for estimating the
component cost of e+uity? ,he Constant-Growth model?
Solution: +ou would want to use the CA#, when you can estimate the firm-s beta with a good
deal of certainty: you would only want to use the constantgrowth model if the firm-s
stock is e!pected to e!perience constant dividend growth.
LG$ 11-- Could you calculate the component cost of e+uity for a stock with nonconstant
e#pected growth rate in di.idends if you didn!t ha.e the information necessary to
compute the component cost using the C&)*? hy or why not?
Solution: +ou could try and ad.ust the constant growth model for initial periods of
nonconstant growth, but doing so would re/uire estimating the growth rate for all of
the nonconstant growth periods.
LG' 11-/ hy do we use market-"ased weights instead of "ook-.alue-"ased weights when
computing the &CC?
Solution: Because we-re interested in determining what the cost of financing the firm-s assets
would be given today-s market situation and the component costs the firm currently
faces, not what the historic prices would have been.
LG- 11-0 Suppose your firm wanted to e#pand into a new line of "usiness +uickly, and that
management anticipated that the new line of "usiness would constitute o.er 12
11-1
Chapter 11, Solutions Cornett, Adair, and Nofsinger
percent of your firm!s operations within $ years3 4f the e#pansion was going to "e
financed partially with de"t, would it still make sense to use the firm!s e#isting cost
of de"t, or should you compute a new rate of return for de"t "ased on the new line of
"usiness?
Solution: 0iven that the new line of business will comprise so much of the firm-s operations, it
probably isn-t appropriate to count on the current, e!isting operations to pay off the
debt. %herefore, the fir should probably compute a new re/uired rate of return for
this firm-s debt.
LG/ 11-1 %#plain why the di.isional cost of capital approach may cause pro"lems if new
pro5ects are assigned to the wrong di.ision3
Solution: 1f pro.ects are assigned to the wrong division, the risk of that division may be
significantly different than the risk of the pro.ect, implying that the pro.ect will be
evaluated with a divisional cost of capital that is much different from what a
pro.ectspecific cost of capital would be.
LG0 11-6 hen will the su"5ecti.e approach to forming di.isional &CCs "e "etter than
using the firm-wide &CC to e.aluate all pro5ects?
Solution: As long as the sub.ective approaches manages to use divisional costs of capital that
are, on average, closer to what the pro.ectspecific costs of capital would be than
the firmwide cost of capital is, the sub.ective approach will improve the firm-s
accept2re.ect decisions.
LG1 11-12 Suppose a new pro5ect was going to "e financed partially with retained earnings3
hat flotation costs should you use for retained earnings?
Solution: 3etained earnings do not carry any flotation cost, so you should use a cost of 4ero.
Problems
7asic )ro"lems
LG$ 11-1 8iddy Corp stock has a "eta of 132, the current risk-free rate is - percent, and the
e#pected return on the market is 1$3- percent3 hat is 8iddy!s cost of e+uity?
Solution: 5sing e/uation ))6:
( )
[ ] 32- 132 31$- 32-
31-
" f " , f
i i " i i 1 +
]
+

11-2
Chapter 11, Solutions Cornett, Adair, and Nofsinger
LG$ 11-2 9aiLai Cos3 stock has a "eta of 131, the current risk-free rate is /32 percent, and the
e#pected return on the market is 12 percent3 hat is 9aiLai!s cost of e+uity?
Solution: 5sing e/uation ))6:
( )
[ ] 32/2 131 312 32/2
312-1
" f " , f
i i " i i 1 +
]
+

LG$ 11-$ :"eron 4nc3 has a ;22 million <face .alue= "ond issue selling for 60 percent of par
that pays an annual coupon of 132- percent3 hat would "e :"eron!s "efore-ta#
component cost of de"t?
Solution: Solving e/uation ))7 for i
$
:
( )
( )
12
12
1
1
1 ;1, 222
Sol.e ;602 ;123-2 for
1
$
$
$
$
i
i
i
i
1

1
+

1
+
' ;
1
+

1

]
+ields i
$
8 .9:;))7, or :.;))7<
LG$ 11-' >aty8id Clothes has a ;1-2 million <face .alue= "ond issue selling for 12' percent
of par that carries a coupon rate of 11 percent, paid semiannually3 hat would "e
>atydid!s "efore-ta# component cost of de"t?
Solution: Solving e/uation ))7 for i
$
:
( )
( )
'2
'2
1
1
1 ;1, 222
Sol.e ;1,2'2 ;-- for
1
$
$
$
$
i
i
i
i
1

1
+

1
+
' ;
1
+

1

]
+ields i
$
8 .9767:=, or 7.67:=< on a semiannual basis. Since the cost of debt is
normally /uoted on a nominal annual basis, we should multiple this semiannual rate
by two to get a /uoted component cost of 7.67:=< ' 6 8 )9.7);6<
LG$ 11-- 4L> has preferred stock selling for 60 percent of par that pays an 1 percent annual
coupon3 hat would "e 4L>!s component cost of preferred stock?
Solution: 5sing e/uation ))>:
11-$
Chapter 11, Solutions Cornett, Adair, and Nofsinger
1
2
;1
;60
3212-, or 132-?
#
$
i
#

LG$ 11-/ *arme 4nc3 has preferred stock selling for 1$0 percent of par that pays an 11 percent
annual coupon3 hat would "e *arme!s component cost of preferred stock?
Solution: 5sing e/uation ))>:
1
2
;11
;1$0
3212$, or 132$?
#
$
i
#

LG' 11-0 @arCry 4ndustries, a maker of telecommunications e+uipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
12 thousand "onds3 4f the common shares are selling for ;20 per share, the preferred
share are selling for ;1'3-2 per share, and the "onds are selling for 61 percent of par,
what would "e the weight used for e+uity in the computation of @arCry!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
2, 222, 222 ;20
2, 222, 222 ;20 1, 222, 222 ;1'3-2 12, 222 361 ;1, 222
;-', 222, 222
;01, $22, 222
3/160, or /1360?
"
" # $

+ + + +

LG' 11-1 :*G 4nc3 has ' million shares of common stock outstanding, $ million shares of
preferred stock outstanding, and - thousand "onds3 4f the common shares are selling
for ;10 per share, the preferred share are selling for ;2/ per share, and the "onds are
selling for 121 percent of par, what would "e the weight used for e+uity in the
computation of :*G!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
11-'
Chapter 11, Solutions Cornett, Adair, and Nofsinger
', 222, 222 ;10
', 222, 222 ;10 $, 222, 222 ;2/ -, 222 1321 ;1, 222
;/1, 222, 222
;1-1, '22, 222
3''61, or ''361?
"
" # $

+ + + +

LG' 11-6 @arCry 4ndustries, a maker of telecommunications e+uipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
12 thousand "onds3 4f the common shares are selling for ;20 per share, the preferred
share are selling for ;1'3-2 per share, and the "onds are selling for 61 percent of par,
what weight should you use for de"t in the computation of @arCry!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
2, 222, 222 ;20
2, 222, 222 ;20 1, 222, 222 ;1'3-2 12, 222 361 ;1, 222
;6,122, 222
;01, $22, 222
312-2, or 123-2?
"
" # $

+ + + +

LG' 11-12 :*G 4nc3 has ' million shares of common stock outstanding, $ million shares of
preferred stock outstanding, and - thousand "onds3 4f the common shares are selling
for ;10 per share, the preferred share are selling for ;2/ per share, and the "onds are
selling for 121 percent of par, what weight should you use for de"t in the
computation of :*G!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
-, 222 1321 ;1, 222
', 222, 222 ;10 $, 222, 222 ;2/ -, 222 1321 ;1, 222
;-, '22, 222
;1-1, '22, 222
32$-0, or $3-0?
"
" # $

+ + + +

LG' 11-11 @arCry 4ndustries, a maker of telecommunications e+uipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
12 thousand "onds3 4f the common shares sell for ;20 per share, the preferred shares
sell for ;1'3-2 per share, and the "onds sell for 61 percent of par, what weight
should you use for preferred stock in the computation of @arCry!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
11--
Chapter 11, Solutions Cornett, Adair, and Nofsinger
2, 222, 222 ;20
2, 222, 222 ;20 1, 222, 222 ;1'3-2 12, 222 361 ;1, 222
;1', -22, 222
;01, $22, 222
311-2, or 113-2?
"
" # $

+ + + +

LG' 11-12 :*G 4nc3 has ' million shares of common stock outstanding, $ million shares of
preferred stock outstanding, and - thousand "onds3 4f the common shares sell for
;10 per share, the preferred share sell for ;2/ per share, and the "onds sell for 121
percent of par, what weight should you use for preferred stock in the computation of
:*G!s &CC?
Solution: 5sing the computation for e/uity weight given in e/uation ))):
$, 222, 222 ;2/
', 222, 222 ;10 $, 222, 222 ;2/ -, 222 1321 ;1, 222
;01, 222, 222
;1-1, '22, 222
3-1-2, or -13-2?
"
" # $

+ + + +

4ntermediate )ro"lems
LG2 11-1$ Suppose that ,ap8ance, 4nc3!s capital structure features /- percent e+uity, $-
percent de"t, and that its "efore-ta# cost of de"t is 1 percent, while its cost of e+uity
is 1$ percent3 4f the appropriate weighted a.erage ta# rate is $' percent, what will
"e ,ap8ance!s &CC?
Solution: 5sing e/uation ))):
( )
( )
&CC 1
3/- 1$? 2 2? 3$- 1? 1 3$'
123261?
" # $ C
" # $
i i i %
" # $ " # $ " # $
+ +
+ + + + + +
+ +

LG2 11-1' 9L) 4ndustries has /3- million shares of common stock outstanding with a market
price of ;1'322 per share3 ,he company also has outstanding preferred stock with a
market .alue of ;12 million, and 2-,222 "onds outstanding, each with face .alue
;1,222 and selling at 62? of par .alue3 ,he cost of e+uity is 1'?, the cost of
preferred is 12?, and the cost of de"t is 032-?3 4f 9L)As ta# rate is $'?, what is the
&CC?
Solution: 5sing e/uation ))):
11-/
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( ) &CC 1
/, -22, 222 ;1'
1'?
/, -22, 222 ;1' ;12, 222, 222 2-, 222 ;1, 222 36
;12, 222, 222
12?
/, -22, 222 ;1' ;12, 222, 222 2-, 222 ;1, 222 36
2-, 222 ;1, 222 36
/, -22, 222 ;1' ;12, 222, 222 2-,
" # $ C
" # $
i i i %
" # $ " # $ " # $
+ +
+ + + + + +


+ +
+
+ +

+
+ +
( )
( )
032-? 1 3$'
222 ;1, 222 36
;61, 222, 222
1'?
;61, 222, 222 ;12, 222, 222 22, -22, 222
;12, 222, 222
12?
;61, 222, 222 ;12, 222, 222 22, -22, 222
22, -22, 222
032-? 1 3$'
;61, 222, 222 ;12, 222, 222 22, -22, 222
330$/1 1'? 32112



+ +
+
+ +
+
+ +
+ ( ) 12? 31122 032-? 1 3$'
113660$?
+

LG2 11-1- Suppose that 97 Cos3 has a capital structure of 01 percent e+uity, 22 percent de"t,
and that its "efore-ta# cost of de"t is 11 percent while its cost of e+uity is 10 percent3
4f the appropriate weighted a.erage ta# rate is 2- percent, what will "e 97!s &CC?
Solution: 5sing e/uation ))):
( )
( )
&CC 1
301 10? 2 2? 322 11? 1 32-
1-320-?
" # $ C
" # $
i i i %
" # $ " # $ " # $
+ +
+ + + + + +
+ +

LG2 11-1/ Suppose that 727, 4nc3 has a capital structure of $0 percent e+uity, 10 percent
preferred stock, and '/ percent de"t3 4f the "efore-ta# component costs of e+uity,
preferred stock and de"t are 1'3- percent, 11 percent and 63- percent, respecti.ely,
what is 727!s &CC if the firm faces an a.erage ta# rate of $2??
Solution: 5sing e/uation ))):
11-0
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
( )
&CC 1
3$0 1'3-? 310 11? 3'/ 63-? 1 3$2
631-6?
" # $ C
" # $
i i i %
" # $ " # $ " # $
+ +
+ + + + + +
+ +

LG2 11-10 Suppose that *B4B> 4ndustries! capital structure features /$ percent e+uity, 0
percent preferred stock, and $2 percent de"t3 4f the "efore-ta# component costs of
e+uity, preferred stock and de"t are 113/2 percent, 63- percent and 0 percent,
respecti.ely, what is *B4B>!s &CC if the firm faces an a.erage ta# rate of $'??
Solution: 5sing e/uation ))):
( )
( )
&CC 1
3/$ 113/2? 320 63-? 3$2 0? 1 3$'
63$-6?
" # $ C
" # $
i i i %
" # $ " # $ " # $
+ +
+ + + + + +
+ +

LG$ 11-11 ,&@>&) 4ndustries has $ million shares of stock outstanding selling at ;10 per
share and an issue of ;22 million in 03- percent, annual coupon "onds with a
maturity of 1- years, selling at 12/ percent of par3 4f ,&@>&)!s weighted a.erage
ta# rate is $' percent and its cost of e+uity is 1'3- percent, what is ,&@>&)!s
&CC?
Solution: ?irst, solve e/uation ))7 for i
$
:
( )
( )
( )
( )
1-
1-
1
1
1
Sol.e )C )*, for
1
1
1
1
;1, 222
Sol.e ;1,2/2 ;0- for
1
/31'0/?
N
$
$
N
$
$
$
$
$
$
$
i
#@
i
i
i
i
i
i
i
i
1

1
+

1
+
' ;
1
+

1

1
]
1

1
+

1
+
' ;
1
+

1

1
]

%hen, using e/uation ))):


11-1
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
( )
( )
&CC 1
$, 222, 222 ;10
1'3-?
$, 222, 222 ;10 ;22, 222, 222 132/
;22, 222, 222 132/
/31'0/? 1 3$'
$, 222, 222 ;10 ;22, 222, 222 132/
302/' 1'3-? 326$/ /31'0/? 1 3$'
113-/6'?
" $ C
" $
i i %
" # $ " # $
+
+ + + +

+
+
+

LG$ 11-16 9ohnny Cake Ltd3 has 12 million shares of stock outstanding selling at ;2$ per share
and an issue of ;-2 million in 6 percent, annual coupon "onds with a maturity of 10
years, selling at 6$3- percent of par3 4f 9ohnny Cake!s weighted a.erage ta# rate is
$' percent, its ne#t di.idend is e#pected to "e ;$322 per share, and all future
di.idends are e#pected to grow at / percent per year, indefinitely, what is its
&CC?
Solution: ?irst, solve e/uation ))7 for i
$
:
( )
( )
( )
( )
10
10
1
1
1
Sol.e )C )*, for
1
1
1
1
;1, 222
Sol.e ;6$- ;62 for
1
63122$?
N
$
$
N
$
$
$
$
$
$
$
i
#@
i
i
i
i
i
i
i
i
1

1
+

1
+
' ;
1
+

1

1
]
1

1
+

1
+
' ;
1
+

1

1
]

Ne!t, use e/uation ))A to solve for i


"
:
1
2
;$322
32/
;2$
3162', or 1632'?
"
$
i g
#
+
+

%hen, using e/uation ))), solve for &ACC:


11-6
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
( )
( )
&CC 1
12, 222, 222 ;2$
1632'?
12, 222, 222 ;2$ ;-23222, 222 36$-
;-23222, 222 36$-
63122$? 1 3$'
12, 222, 222 ;2$ ;-23222, 222 36$-
31$11 1632'? 31/16 63122$? 1 3$'
1/361/$?
" $ C
" $
i i %
" # $ " # $
+
+ + + +

+
+
+

LG' 11-22 7etter)ie 4ndustries has $ million shares of common stock outstanding, 2 million
shares of preferred stock outstanding, and 12 thousand "onds3 4f the common shares
are selling for ;'0 per share, the preferred shares are selling for ;2'3-2 per share,
and the "onds are selling for 66 percent of par, what would "e the weights used in
the calculation of 7etter)ie!s &CC?
Solution: 5sing the computations for component weights given in e/uation ))):
$, 222, 222 ;'0
$, 222, 222 ;'0 2, 222, 222 ;2'3-2 12, 222 366 ;1, 222
;1'1, 222, 222
;166, 622, 222
302-', or 023-'?
2, 222, 222 ;2'3-2
$, 222, 222 ;'0 2, 222, 222 ;2'3-2 12, 222 366 ;1, 222
;'6, 222, 222
;166, 62
"
" # $
#
" # $

+ + + +

+ + + +

2, 222
32'-1, or 2'3-1?
12, 222 366 ;1, 222
$, 222, 222 ;'0 2, 222, 222 ;2'3-2 12, 222 366 ;1, 222
;6, 622, 222
;166, 622, 222
32'6-, or '36-?
$
" # $

+ + + +

LG1 11-21 Suppose that 7rown-*urphies! common shares sell for ;163-2 per share, are
e#pected to set their ne#t annual di.idend at ;3-0 per share, and that all future
di.idends are e#pected to grow "y ' percent per year, indefinitely3 4f 7rown-
*urphies faces a flotation cost of 1$? on new e+uity issues, what will "e the
flotation-ad5usted cost of e+uity?
Solution: 5sing e/uation ))::
11-12
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
1
2
;3-0
32'
;163-2 31$ ;163-2
320$/, or 03$/?
"
$
i g
# ?
+

&d.anced )ro"lems
LG2 11-22 & firm is considering a pro5ect that will generate perpetual after-ta# cash flows of
;1-,222 per year "eginning ne#t year3 ,he pro5ect has the same risk as the firmAs
o.erall operations and must "e financed e#ternally3 %+uity flotation costs 1'? and
de"t issues cost '? on an after-ta# "asis3 ,he firmAs 8D% ratio is 2313 hat is the
most the firm can pay for the pro5ect and still earn its re+uired return?
Solution: 1f the $2" ratio is 9.:, then $2($B"* will be 9.:2).: 8 .>>>> and "2($B"* will be
).92).: 8 .777=.
%hen, using e/uation ))), solve for &ACC:
( ) &CC 1
3---/ 1'? 3'''' '?
63---/?
" $ C
" $
i i %
" # $ " # $
+
+ + + +
+

LG2 11-2$ & firm has -,222,222 shares of common stock outstanding, each with a market price
of ;1322 per share3 4t has 2-,222 "onds outstanding, each selling for ;1223 ,he
"onds mature in 12 years, ha.e a coupon rate of 1?, and pay coupons semi-
annually3 ,he firm!s e+uity has a "eta of 13', and the e#pected market return is
1-?3 ,he ta# rate is $-? and the &CC is 1-?3 Calculate the risk free rate3
Solution: ?irst, solve e/uation ))7 for i
$
:
11-11
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
( )
( )
( )
22
22
1
1
1
Sol.e )C )*, for
1
1
1
1
;1, 222
Sol.e ;122 ;'2 for
1
-30210? 2 113'2$'?
N
$
$
N
$
$
$
$
$
$
$
i
#@
i
i
i
i
i
i
i
i
1

1
+

1
+
' ;
1
+

1

1
]
1

1
+

1
+
' ;
1
+

1

1
]

%hen solve e/uation ))) for i
"
:
( )
( )
( )
&CC 1
-, 222, 222 ;1322 2-, 222 ;122
1-? 113'2$'? 1 3$-
-, 222, 222 ;1322 2 2-, 222 ;122 -, 222, 222 ;1322 2 2-, 222 ;122
1-? 3///0 3$$$$ 113'2$'? 1 3$-
1-? 3///0 23'020?
123-26$? 3///0
" $ C
"
"
"
" $
i i %
" # $ " # $
i
i
i
+
+ + + +

+
+ + + +
+
+

123-26$?
3///0
11306$6?
"
"
"
i
i
i

?inally, putting this into e/uation ))= and solving for the riskfree rate:
( )
11306$6? 13' 1-?
11306$6? 21? 13'
3' 21? 11306$6?
3' 2322/1?
2322/1?
3'
-3-1-$?
" f Avg , f
f f
f f
f
f
f
f
i r " r r
r r
r r
r
r
r
r
1 +
]
1 +
]
+

11-12
Chapter 11, Solutions Cornett, Adair, and Nofsinger
LG/ 11-2' &n all-e+uity firm is considering the pro5ects shown "elow3 ,he ,-"ill rate is '
percent and the market risk premium is 0 percent3 4f the firm uses its current &CC
of 12 percent to e.aluate these pro5ects, which pro5ect<s=, if any, will "e incorrectly
re5ected?
Projet E!"ete# Return $et%
& 132? 23-
7 1632? 132
C 1$32? 13'
8 1032? 13/
Solution: 5sing the firm-s &ACC of )6 percent as the 133 benchmark, pro.ect A would be
re.ected. 5sing e/uation ))6, the pro.ectspecific benchmarks for each pro.ect
should be:
( )
[ ]
( )
[ ]
( )
[ ]
( )
[ ]
@or )ro5ect &E
'? 23- 0?
03-?
@or )ro5ect 7E
'? 132 0?
123'?
@or )ro5ect CE
'? 13' 0?
1$31?
@or )ro5ect 8E
'? 13/ 0?
1-32?
" f " , f
" f " , f
" f " , f
" f " , f
i i " i i
i i " i i
i i " i i
i i " i i

1 +
]
+

1 +
]
+

1 +
]
+

1 +
]
+

1f #ro.ect A-s e!pected return of :< had been compared to the pro.ectspecific
re/uired return of ;.7<, it would have been accepted. %herefore, #ro.ect A would
have been incorrectly re.ected if the firmwide &ACC had been used as its
benchmark.
LG/ 11-2- &n all-e+uity firm is considering the pro5ects shown "elow3 ,he ,-"ill rate is '
percent and the market risk premium is 0 percent3 4f the firm uses its current &CC
of 12 percent to e.aluate these pro5ects, which pro5ect<s=, if any, will "e incorrectly
accepted?
11-1$
Chapter 11, Solutions Cornett, Adair, and Nofsinger
Projet E!"ete# Return $et%
& 132? 23-
7 1632? 132
C 1$32? 13'
8 1032? 13/
Solution: 5sing the firm-s &ACC of )6 percent as the 133 benchmark, pro.ects B, C and $
would be accepted. 5sing e/uation ))6, the pro.ectspecific benchmarks for each
pro.ect should be:
( )
[ ]
( )
[ ]
( )
[ ]
( )
[ ]
@or )ro5ect &E
'? 23- 0?
03-?
@or )ro5ect 7E
'? 132 0?
123'?
@or )ro5ect CE
'? 13' 0?
1$31?
@or )ro5ect 8E
'? 13/ 0?
1-32?
" f " , f
" f " , f
" f " , f
" f " , f
i i " i i
i i " i i
i i " i i
i i " i i

1 +
]
+

1 +
]
+

1 +
]
+

1 +
]
+

1f #ro.ect C-s e!pected return of )A< had been compared to the pro.ectspecific
re/uired return of )A.:<, it would have been re.ected. %herefore, #ro.ect C would
have been incorrectly accepted if the firmwide &ACC had been used as its
benchmark.
LG0 11-2/ Suppose your firm has decided to use a di.isional &CC approach to analyFe
pro5ects3 ,he firm currently has ' di.isions, & through 8, with a.erage "etas for
each di.ision of 23/, 132, 13$ and 13/, respecti.ely3 4f all current and future pro5ects
will "e financed with half de"t and half e+uity, and if the current cost of e+uity
<"ased on an a.erage firm "eta of 132 and a current risk-free rate of 0 percent= is 1$
percent and the after-ta# yield on the company!s "onds is 1 percent, what will the
&CCs "e for each di.ision?
Solution: 5sing e/uation ))6, we can solve for the e!pected rate of return on the market:
11-1'
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
( )
( )
( )
1$? 0? 132 0?
/? 0?
1$?
" f " , f
,
,
,
i i " i i
" i
" i
" i
1 +
]
+ 1
]
1
]

3eusing e/uation ))6, we can solve for the divisional costs of e/uity using the
average divisional betas:
( ) [ ]
( ) [ ]
( ) [ ]
( )
@or 8i.ision &E 0? 23/ 1$? 0? 123/?
@or 8i.ision 7E 0? 132 1$? 0? 1$?
@or 8i.ision CE 0? 13$ 1$? 0? 1'31?
@or 8i.ision 8E 0
" f " , f
" f " , f
" f " , f
" f " , f
i i " i i
i i " i i
i i " i i
i i " i i

1 + +
]
1 + +
]
1 + +
]
1 +
]
[ ] ? 13/ 1$? 0? 1/3/? +
?inally, we can solve for the divisional &ACCs using e/uation ))):
( )
( )
( )
@or 8i.ision &E &CC 1 3- 123/? 3- 1? 63$?
@or 8i.ision 7E &CC 1 3- 1$? 3- 1? 123-?
@or 8i.ision CE &CC 1 3- 1'31? 3- 1? 113'?
@or 8i.isio
" $ C
" $ C
" $ C
" $
i i %
" # $ " # $
" $
i i %
" # $ " # $
" $
i i %
" # $ " # $
+ +
+ + + +
+ +
+ + + +
+ +
+ + + +
( ) n 8E &CC 1 3- 1/3/? 3- 1? 123$?
" $ C
" $
i i %
" # $ " # $
+ +
+ + + +
Rese%r& It' ()eb*E!erises+, Fin#in- t&e $e.ore*T%! Cost o. /ebt0 i
D
@or component de"t costs, we!d like to use the yield to maturity on "onds that resem"le the
maturity of our potential de"t as possi"le3 Let!s assume that we want to find a "ond issue
with appro#imately 12 years until maturity <as of 9anuary, 2220= for 7ear Stearns3 Luckily,
7ear Stearns has +uite a few outstanding "ond issues to choose from, and we can access the
information on these issues on the GahooH @inance page3 Go to httpEDDfinance3yahoo3comD
and start "y clicking on I4n.estingJ and then I7ondsJ as shown to the rightE
,hen enter 7ear Stearns in the I7ond LookupJ "o# and click on ISearchJ as shown "elowE
Gou!ll "e presented with a list of 7ear Stearns! outstanding "onds sorted in order of
decreasing maturityE

:nce you!.e identified the "ond with the maturity closest to the maturity you want, click on
the I4ssueJ entry and look up the Gield to *aturity3
Gour turnE go to the GahooH @inance we" site and find the G,* on the "ond with a maturity
that!s as close as possi"le to 12 years from today!s date3
11-1-
Chapter 11, Solutions Cornett, Adair, and Nofsinger

Inte-r%te# 1ini%se, )ACC .or % Ne2 Projet
Lily*ac Studios, a national chain of photography studios, is considering opening up a chain
of coffee shopDart galleries3 hile the e#isting operations of the firm ha.e a "eta of 1310,
the new chain is e#pected to ha.e a "eta of 2313
Lily*ac currently has -22,222 shares of common stock outstanding, which are selling for
;/$302 per share, and a ;12 million dollar "ond issue, selling at 12' percent of par3 ,he
e#pected market risk premium is / percent, and the current risk-free rate is -3-?3 ,he
"onds pay an 1 percent semiannual coupon and mature in 22 years3
Lily*ac!s ne#t e#pected di.idend is ;'322 per share, and future di.idends are e#pected to
grow at '? per year3
,he current operations of the firm produce %74, of ;11 million per year, and the chain!s
operations are e#pected to add only ;2- million per year to that3 ,he new chain will "e
funded with /-? percent e+uity and $-? de"t, and estimated flotation costs are e#pected to
"e 12 percent and - percent, respecti.ely3
hat should "e the &CC for the new chain of coffee shops?
Solution: 5sing the constant growth formula along with the flotation cost of e/uity, )6 percent
of C=A.;6 will be C;.=>, so the cost of e/uity will be e/ual to:
1
2
;'322
32'
;/$302 ;03/-
3111$,or 1131$?
"
$
i g
# ?
+

Notice that, without the flotation cost, this would be:


1
2
;'322
32'
;/$302
31221,or 12321?
"
$
i g
#
+
+

&hich is an increase of )).)A< )9.6:< 8 .:=< due to the flotation cost, so if we


use the CA#, approach, the cost of e/uity will be e/ual to:
11-1/
Chapter 11, Solutions Cornett, Adair, and Nofsinger
( )
[ ]
,)r
32-- 231 32/
312$, or 123$?
" f " o.ect , f
i r " r r 1 +
]
+

&hich would be similarly ad.usted to )9.A< B .:=< 8 )).)=<. %aking an average


of the two costs of e/uity, we will use ()).)A< B )).)=<*26 8 )).)>7<.
%he +%, on the new bonds issued to finance this pro.ect will be:
( )
( )
( )
'2
'2
1
1
1 ;1222
Sol.e ;1,2'2- 32-K;1,2'2 ;'2 for
1
$
$
$
$
i
i
i
i
1

1
+

1
+
' ;
1
+

1

]
&hich gives us an annual i
$
of :.)66><.
?inally, the current "B1% puts the firm in the A:< ta! bracket, so the additional
"B1% generated by the pro.ect will be ta!ed at an average marginal ta! rate of:
&hich gives us an afterta! cost of debt of :.)66><'().A79>*87.6;=A<
5sing these component costs for e/uity and debt, and taking the capital structure of
the new chain, we get a &ACC of:
11-10