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Solutions to Chapter 12

The Cost of Capital
1.

The yield to maturity for the bonds (since maturity is now 19 years) is the interest
rate (r) that is the solution to the following equation:
[$80  annuity factor(r, 19 years)] + [$1,000/(1 + r) 19] = $1,050
Using a financial calculator, enter: n = 19, FV = 1000, PV = (-)1050, PMT = 90, and
then compute i = 7.50%
Therefore, the after-tax cost of debt is: 7.50%  (1 – 0.35) = 4.88%

2.

r = DIV/P0 = $4/$40 = 0.10 = 10%

3.

 D

 P

 E

WACC  
 rdebt  (1  TC )  
 rpreferred   
 requity 
V
V
V





= [0.3  7.50%  (1 – 0.35)] + [0.2  10%] + [0.5  12.0%] = 9.46%
DIV0 (1  g)
DIV1
$5  1.05
g 
g 
 0.05  0.1375  13.75%
P0
P0
$60

4.

r

5.

The total value of the firm is $80 million. The weights for each security class are as
follows:
Debt:
Preferred:
Common:

D/V = 20/80 = 0.250
P/V = 10/80 = 0.125
E/V = 50/80 = 0.625

 D

 P

 E

WACC  
 rdebt  (1  TC )  
 rpreferred   
 requity 
V
V
V





= [0.250  6%  (1 – 0.35)] + [0.125  8%] + [0.625  12.0%] = 9.475%
6.

Executive Fruit should use the WACC of Geothermal, not its own WACC,
when evaluating an investment in geothermal power production. The risk of
the project determines the discount rate, and in this case, Geothermal’s
WACC is more reflective of the risk of the project in question. The proper
discount rate, therefore, is not 12.3%. It is more likely to be 11.4%.

7.

The flotation costs reduce the NPV of the project by $1.2 million. Even so,
project NPV is still positive, so the project should be undertaken.

12-1

12-2 .

5 million $15.5 million *Number of shares = Explanation 1.34%.8 The WACC is the same as the cost of equity. which is 12%.42% 20 . exceeds the cost of capital.8. This calculation ignores the fact that bonds selling at discounts from. which can be calculated using the CAPM: requity = rf + (rm – rf) = 4% + (0. Security Debt Equity Total Market Value $ 5.10  par value of $5 million $30 per share  500. If it is the book value.34% 9. The cost of equity capital is the required rate of return on equity. 8 years) = $546.000 shares * $10 million book value  500.90  8%) = 11. Since the firm is all-equity financed: asset beta = equity beta = 0. is:  D   E  WACC    rdebt  (1  TC )    requity   V   V  = [0. The 12. which can be calculated from the CAPM as follows: 4% + (0. 5      11. with a tax rate of zero.2%] = 9. The analyst should be using yield to maturity instead of current yield to calculate cost of debt. BCCI should accept the project. 5 20 . The rate on Buildwell’s debt is 5 percent.40)    15%  12. [This answer assumes the value of the debt provided is the market value. then 12. 10. par value provide expected returns determined in part by expected price appreciation or depreciation. Therefore.70  11.5% value calculated by the analyst is the current yield of the firm’s outstanding debt: interest payments/bond value.08 This is the most BCCI should pay for the project. The present value of the project cash flows is: $100. The internal rate of return.0 million $20.000 $20 book value per share  D   E  WACC    rdebt  (1  TC )    requity   V   V   5.5   15   9%  (1  0.80  10%) = 12% 12.5% would be the 12-3 .30  5%  (1 – 0)] + [0.2% The weighted average cost of capital.556.000  annuity factor(9. or premiums over.

50  10. The 9% coupon bond has a yield to maturity of 10% and sells for 93.0910) = $935.50  10%   18.83% The market value of the issue is: 0.32 = 32% Another estimate. a.2  8%) = 13. The price per $1.50 million Therefore. It is based on an historic growth rate that is impossible to sustain. The after-tax cost of debt is: (1 – 0. compute PV = $938.77  23. one estimate would be: DIV1/P0 + g = 0. would be: r = rf + (rm – rf) = 4% + (1.77 million The 10% coupon bond sells for 94% of par value.86% of face value: n = 10.77 23. FV = 1000.35)  10.02 + 0. 10 years)] + ($1.000/1. PMT = 100.83%  10.6% 14.average coupon rate of outstanding debt. 15. the weighted-average before-tax cost of debt is:  18. PMT = 90. FV = 1000.82 The total market value of the bonds is: 12-4 .] 13. a.55 Therefore.9386  $20 million = $18. i = 10%. it requires the use of the sustainable growth rate.94  $25 million = $23. b. PV = ()940. In other words. The estimate of 32% seems far less reasonable. Using the recent growth rate of 30% and the dividend yield of 2%.46% b.30 = 0. based on the CAPM.50     18. the market value of the issue is: 0.000 par value is: [$80  annuity factor(9%.83%: n = 15. and has a yield to maturity of 10.80% The bonds are selling below par value because the yield to maturity is greater than the coupon rate. The [DIV1/P0 + g] rule requires that the growth rate of dividends per share must be viewed as highly stable over the foreseeable future. compute i = 10.77  23. which would also be a poor estimate of the required rate of return on the firm’s debt.46% = 6.

82 market value  $9.000 par value There are: $2 million/$20 = 100. The market price of the preferred stock is $15 per share.000 shares of preferred stock. 12-5 .36 million $1. so that the total market value of the preferred stock is $1.$10 million par value  $935.5 million.

the WACC of the firm (based on its existing mix of projects) is only 11.648  14%] = 11. a.4  0) + (0.  D   E  WACC    rdebt  (1  TC )    requity   V   V  = [0.33%] + [0. Use a discount rate of 10. the discount rate for the new venture is: r = 4% + 1. r = rf + (rm – rf) r = 4% + (1.049  13. If the company plans to expand its present business. Using a beta of 1.1 million/$0.0% The yield to maturity for the firm’s debt is: rdebt = 9% The rate for the preferred stock is: rpreferred = $2/$15 = 0. Therefore.303  9%  (1 – 0.4  10% = 18% 12-6 .4  4%  (1 – 0. Therefore.3% 4.2  10%) = 16% b.9 c.00 million $30. However.56% d. Market Value $ 9.6  1.10 = 1 million shares of common stock. it will incorrectly go ahead with the venture in home computers.4.4)] + [0.36%.5) = 0.36 million $ 1. e.8  10% = 14% Using the capital structure derived in the previous problem.40)] + [0. The IRR on the computer project is less than the WACC of firms in the computer industry.9% 64. then the WACC is a reasonable estimate of the discount rate since the risk of the proposed project is similar to the risk of the existing projects. The market price of the common stock is $20 per share. Weighted average beta = (0. so that the total market value of the common stock is $20 million.50 million $20.8% 100. the project should be rejected.There are: $0.86 million Percent 30.36% 17. we can calculate WACC as:  D   P   E  WACC    rdebt  (1  TC )    rpreferred     requity   V   V   V  = [0. 18.1333 = 13.56%. The WACC of optical projects should be based on the risk of those projects. If the firm uses this figure as the hurdle rate. the capital structure is: Security Bonds Preferred Stock Common Stock Total 16.33% The rate for the common stock is: requity = rf + (rm – rf) = 6% + 0.6  16%] = 10.

12-7 .

The new financing mix for the firm is: E = $1. with allequity financing. then the after-tax and before-tax costs of debt are identical. and as the cost of equity if the project is equity financed. The WACC will remain unchanged because business risk is unchanged.7 If the cost of debt is still 9%. If the tax authority is collecting more income from the firm. so each share is now riskier. Use the fact that. This is less than the previous value of 12.8%] = 11.19. The after-tax cash flows the firm would generate for its owners would also be lower. In fact.) 20. There is no longer any leverage. The net effect of Big Oil’s transaction is to leave the firm with $200 million more debt (because of the borrowing) and $200 million less equity (because of the dividend payout).88% If Big Oil issues new equity and uses the proceeds to pay off all of its debt.585. this does not imply that the firm would be worth more.000   0.631  r equity] = 12. This would reduce the value of the firm even if the cash flows were discounted at a lower rate. the cost of equity would be the same as the firm’s WACC. Even if the WACC were lower when the firm’s tax rate is higher.757  12.000 and D = $585. WACC must still be 12.41% We solve to find that: requity = 13. Total assets and business risk are unaffected.631 V $1. the business risk is spread over a smaller equity base.7 E $1. for the all-equity firm.7 Therefore: D $585. With the now higher leverage.  D   E  WACC    rdebt  (1  TC )    requity   V   V  = [0. However. the cost of equity will increase. 22.243  9%  (1 – 0)] + [0. WACC would then become:  D   E  WACC    rdebt  (1  TC )    requity  V V     = [0.41%. even at the new financing mix. In fact. the cost of equity will decrease. if the project poses risk comparable to the risk of the firm’s other 12-8 . there is no interest tax shield.585.369 and   0. (We use the WACC derived in the absence of interest tax shields since. If Big Oil does not pay taxes. the value of the firm will fall.369  9%  (1 – 0)] + [0.88%. which is 11. then we solve for the new cost of equity as follows.56% 21.8%. so the equity becomes safer and therefore commands a lower risk premium.7 V $1. This reasoning is faulty in that it implicitly treats the discount rate for the project as the cost of debt if the project is debt financed.

which is a weighted average of the costs of both debt and equity. the proper discount rate is the firm’s cost of capital.projects. 12-9 .

1045  8. Bernice’s CAPM calculation indicates that the correct value for the equity rate is 11%. is not selling at par.45 59. the rate of return is: rpreferred  DIV P0  $6  0. not book.1791  8%  (1 – 0.5970  11%) = 9.75%  (1 – 0.35)] + (0. The preferred stock. values.067  0. Brinestone’s memo.00% 12-10 .6%) + (0. Mr.60 11. respectively. it is not the expected rate of return that investors demand on shares of stock with the same risk as Sea Shore Salt. as in Mr. so Mr. Brinestone. the WACC. with the preferred selling at $70 per share. The market value weights are computed as follows: Comment Bank loan Bond issue Preferred stock Common stock valued at face amount valued at par $70  1 million shares $40  10 million shares Amount (millions) $120 80 70 400 $670 Percent of total 17.00 7.75 8. however. Brinestone’s estimate of the cost of equity is his target value for the book return on equity. the weights used to calculate the WACC should reflect market.35)] + [0.117  11.75%. should be 9%: WACC = [0. Finally.1194  7. In fact. This value is broadly consistent with the rate one would infer from the constant growth dividend discount model (which seems appropriate for a mature firm like this one with stable growth prospects). The bank loan and bond issue offer pre-tax rates of 8% and 7.70 100.00 Therefore.7% P0 $40 Thus. Brinestone’s returns for other securities should be modified to reflect the expected returns these securities currently offer to investors. The dividend discount model implies a cost of equity of a bit more than 11 percent: requity  DIV1 $2 g   0.6% $70 This makes sense: the pre-tax return on preferred should exceed that on the firm’s debt.91 11.Solution to Minicase for Chapter 12 Bernice needs to explain to her boss. that appropriate rates of return for cost of capital calculations are the rates of return that investors can earn on comparable risk investments in the capital market. Similarly. Mr. which serves as the corporate hurdle rate. Mr. Brinestone’s assertion that the rate of return on preferred is 6% is incorrect. These are the prices that investors would pay to acquire the securities.086  8. it appears that Bernice’s calculation is correct.94 10.00 Rate of return (%) 8.