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MBA711 - Chapter11 - Answers to All Homework Problems

MBA711 - Chapter11 - Answers to All Homework Problems

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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

]

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

]

"

:

1

2

;$322

32/

;2$

3162', or 1632'?

"

$

i g

#

+

+

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

# ?

+

1

2

;'322

32'

;/$302

31221,or 12321?

"

$

i g

#

+

+

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 +

]

+

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

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