Chapter 14

The Cost of Capital

14-1. Templeton’s investment of $400M will be financed with $300M in debt and $100M in equity.
Thus after the purchase, Templeton’s balance sheet (market value and book value, at t  0) will
look like this:
ASSETS DEBT
$400,000,000 $300,000,000

EQUITY
$100,000,000
$400,000,000 $400,000,000
Thus Templeton is using ( $400,000,000 )  75% in debt financing, and ( $400,000,000 )  25% in equity
$300,000,000 $100,000,000

financing. Its debt and equity weights are therefore 75% and 25%, respectively.
14-2. As noted in Checkpoint 14.1, we use the firm’s market values, not its book values, to determine its
capital structure weights. Thus we don’t even need Emerson Electric’s book values to answer this
problem—only its market values.
For example, to find the market value of Emerson’s equity, we solve:
WCS = MV of common stock/Total MV of all financing sources
= $35,960 million/$42,532 million = 83.9%
14-3. In this problem, we are to determine individual costs for various funding sources.
a. We have a bond with the following details:
Given
Par value $1,000
Market Value $1,000
Number of years 20
Coupon rate 11%
Interest periods/year 2
Tax rate 30%

Solution
Semi-annual Yield to maturity on bond 5.50%
Annual YTM (2 x simi-annual YTM) 11.00%
Cost of capital from this bond =(1-Tax rate)* Yield on bond 7.70%

352
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 Solutions to End-of-Chapter Problems—Chapter 14 353
The before-tax rate YTM on the bond is first calculated to be 5.5%. Note that this rate is
YTM/2, implying that the YTM is (5.5%)*(2) = 11.0%.We can also solve for the semi-annual
YTM using Excel’s RATE function:
= RATE(nper, pmt, PV, FV)   RATE(20*2, 110/2, −1000, 1000)
 YTM  5.5%.
Again, note that this rate is YTM/2, implying that the YTM is (5.5%)*(2) = 11.0%.
Of course, the firm’s interest payments are tax deductible, so we need one more step: to turn
this before-tax YTM into an after-tax cost. To do this, we simply multiply the YTM by (1  T),
where T is the firm’s marginal tax rate (expressed as a decimal). Thus here we have (11.0%) 
(1  0.30)  7.7%. This is the effective after-tax cost that the firm would pay to issue new bonds
comparable in risk to these 11% coupon rate bonds.
b. We have common stock with the following features:
Last year dividend $1.80
Market price of stock $30.00
Dividend growth rate 7%
Since this stock is in constant growth, we can use equation 14-3a to solve for the cost of
common equity implied by the values we were given. We proceed as follows:

D0 (1  g)
kcs  g
P0

kcs = [$1.80 * (1.07)]/$30 + 0.07 = 6.42% + 7% = 13.42%.

(Note that we assume that the dividend “last year” is at t  0, not t  1, so that we can simply
find next year’s dividend, D1, as $1.80  (1  g).)

c. Now we consider the following preferred stock:

Par Value $100.00

Dividend rate 10%
Price $125.00
To find the cost of preferred stock financing, we use equation 14-2a:
Div ps
k ps 
Pps

For our preferred, we can find the dividend as 10%  $100 par value  $10.
kps = $10/$125 = 8.0%
d. Here, we have a bond selling to yield 10%.
The cost of debt before tax is therefore 10%. However, because firms can deduct interest, the
after-tax cost of this bond is only (10%)  (1  T); since T  34%, the after-tax cost is (10%) 
(1  0.34)  6.6%.

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354  Titman/Keown/Martin  Financial Management, Thirteenth Edition

14-4. In this problem, as in Problem 14-3, we are considering the costs of various components of capital.
a. First we have a bond with the following features:

Face value $1,000.00

Market Value $1,125
Number of years 10
Compounding periods/year 2
Coupon rate 12%
Tax rate 34%

Using equation 9-2c, we can solve for the yield to maturity (YTM, or i) as follows:
1  1 20  $1000
$1125  (12%/2)  ($1000)   (1i )    i  4.9972%.  i  4.9972%
i  (1  i)
20

The before-tax rate calculated from this equation is 4.9972%. Note that this rate is YTM/2,
implying that the YTM is (4.9972%)*(2) = 9.9944%. Of course, we can also solve for YTM
using Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(10*2, 120/2, 1125, 1000)  rate  4.9972%.
Again, note that this rate is YTM/2, implying that the YTM is (4.9972%)*(2) = 9.9944%.
Note that it’s not surprising that the YTM is less than the coupon rate: Since this bond is
selling at a premium, the coupon rate is higher than the market’s required rate of return
(review the “Second relationship” in Section 9.3).
Of course, the YTM is pre-tax. To find the effective after-tax cost to the firm, we multiply our
9.9944% by (1  T): (9.9944%)  (1  0.34)  6.60%. Although investors demand a return of
almost 10% on these bonds, the effective after-tax cost to our firm is only 6.60%, since the
firm can deduct 34% of the interest payments.
b. It is usually relatively easy to determine a firm’s cost of debt, since its bonds’ YTMs give us
the market’s required return for bonds of the relevant risk classes. However, if a firm’s bonds
are not frequently traded, then we’re not automatically given this up-to-date market information.
In that case, we can use the methods shown in Chapter 9 to estimate the bonds’ YTMs. For
example, we can use the bonds’ credit spreads (the spread of the bond’s YTM over the yield of
comparable Treasury bonds of the same maturity), based on their credit ratings. (This method
is discussed in Section 9.2; see especially Table 9.4.)
c. Now, we’re considering the following common stock:
dividend paid last year  $1.75
constant growth in dividends, per year  8%
par value of common stock  $15
current stock price  $28.00
Using equation 14-3a (which assumes the firm is in constant growth), we have the following:
D1 D* (1  g)
kcs  g 0 g
P0 P0
$1.75  (1.08)
  0.08  6.75%  14.75%.
$28.00

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 Solutions to End-of-Chapter Problems—Chapter 14 355
Note that we assume that the dividend “last year” is at t  0, not t  1, so that we can simply
find next year’s dividend, D1, as $1.75  (1  g). Note also that we did not use the common
stock’s par value—that value does not represent the market’s current assessment of this stock;
instead, it is an arbitrary accounting number.
d. For a preferred stock with the following characteristics:
dividend  10%
par value  $125
price  $150
we first need to find the dividend amount. Since the preferred pays 10% of par, it must pay
(10%)  ($125) = $12.50/year. Given the current stock price of $150, this implies a required
return of ( $12.50
$150
)  8.33%. (Note that this is less than the dividend rate of 10%, since the stock’s
price is greater than par. Thus the fixed $12.50 dividend is a smaller percentage of the [higher]
price than it is of the [lower] par value.)
e. Finally, we have a bond yielding 13%, with a tax rate of 34%.
Since the YTM is given, all we need to do is find the after-tax equivalent: (13%)  (1  0.34) 
8.58%.
14-5. a. Since we don’t have a current market price for Mindflex’s debt, we are using the YTM on
a
portfolio of similar debt. “Similar” here means matched on the bond risk characteristics that are
priced—primarily maturity and credit rating (for default risk) in this case. The portfolio of
comparable bonds yields 9%, so we can assume this is also the pre-tax yield for Mindflex’s
bonds. However, given the tax rate of 34%, Mindflex’s effective after-tax cost is only (7%) 
(1  0.34)  4.62%.
b. Mindflex’s (constant growth) stock looks like this:

Dividend paid last year $1.30

Market price of stock $30.00
Dividend growth rate 4%

Using equation 14-3a, we have the following:

kcs = [$1.30 * (1.04)]/$30 + 0.04 = 4.51% + 4% = 8.51%.
(Note that we assume that the dividend “last year” is at t  0, not t  1, so that we can simply
find next year’s dividend, D1, as $1.30  (1  g).)
c. Mindflex now has the following frequently traded bond issue:

Par or face value $1,000.00

Market Value $1,125
Number of years 20
Coupon rate 13%
Compounding periods/year 2
Tax rate 34%

i  5.70%

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356  Titman/Keown/Martin  Financial Management, Thirteenth Edition
The before-tax rate calculated from this equation is 5.70%. Note that this rate is YTM/2,
implying that the YTM is (5.70%)*(2) = 11.40%. Of course, we can also solve for YTM using
Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(20*2, 130/2, 1125, 1000)  rate  5.70%
so that the YTM is (5.70%)*(2) = 11.40%. It is not surprising that this bond’s YTM is less than its
coupon rate, since the bond is selling at a premium. However, it is a problem that this bond’s YTM is
greater than the firm’s cost of common stock. This cannot happen: Since both the debt and the common
equity of a firm derive their value from the same underlying assets, but the equity is a residual claim, the
equity is riskier. It therefore must have a higher required/promised/expected return than the debt.
Taking the 11.40% as the YTM, we find the effective after-tax cost to be (11.40%)  (1  0.34) 
7.52%.
d. For Mindflex’s preferred stock, we have:

Par Value $125.00

Market Value $90.00
Dividend rate 8%

First, we need to find the dividend amount. Since the preferred pays 8%of par, it must pay
(8%)  ($125)  $10/year. Given the current stock price of $90, this implies a required return
of ($10/$90) = 11.11%. (Note that this is more than the dividend rate of 8%, since the preferred
stock’s price is less than par.)
Thus, the required return on the preferred is less than that of the bond from part (c)—another
hint that the bond’s price is off. However, oddly, it is possible for the preferred stock of a
company to have a lower yield than its debt, even though the preferred is riskier. This is because
preferred may allow corporate investors to deduct 70% of dividends (the dividends-received
deduction, which was discussed in the text in Chapter 3), while the debt will not. This may allow
corporate investors to accept lower pre-tax yields on preferred than on debt. Thus the tax
benefits can lead to anomalies in the pre-tax yields. (However, it’s more likely that our case is
just a data problem.)
14-6. a. We are to find the cost of capital for a bond with the following characteristics:
YTM  8%
T  34%
The YTM of 8% is the rate for comparable bonds—bonds with the same credit rating and
maturity. We can assume that our bonds, with the same risk factors, have the same YTM.
On an after-tax basis, the cost of this debt is (8%)  (1  0.34)  5.28%.
b. Now we will find the cost of a constant-growth stock with these details:

Last year dividend $2.05

Market price of stock $25.00
Dividend growth rate 5%

Using the constant growth model rearranged as equation 14-3a, we have the following:
kcs = [$2.05 * (1.05)]/$25 + 0.05 = 8.61% + 5% = 13.61%.
(Note that we assume that the dividend “last year” is at t  0, not t  1, so that we can simply
find next year’s dividend, D1, as $2.05  (1  g).)

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 Solutions to End-of-Chapter Problems—Chapter 14 357
c. Now we have the following bond:
par value  $1000
coupon rate  12%
market value  $1150
maturity (years)  20
marginal tax rate  34%
Using equation 9-2, we can solve for the semi-annual yield to maturity (YTM, or i) as follows:

$1150 = (12%/2)*($1000)*{[1 – 1/(1 + i)40]/i + $1000/(1 + i)40 → i = 5.112%,

so that the YTM is (5.112%)*(2) = 10.225%. Of course, we can also solve for YTM using
Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(20*2, 120/2, 1150, 1000)  rate  5.112%.
Again, note that this rate is YTM/2, implying that the YTM is (5.112%)*(2) = 10.225%.
It is not surprising that this bond’s YTM is less than its coupon rate, since the bond is selling
at a premium. However, it is a problem that this bond’s YTM is greater than the firm’s cost of
common stock. This cannot happen: Since both the debt and the common equity of a firm derive
their value from the same underlying assets, but the equity is a residual claim, the equity is
riskier. It therefore must have a higher required/promised/expected return than the debt.
Taking the 10.225% as the YTM, we find the effective after-tax cost to be (10.225%) 
(1  0.34)  6.748%.
d. Finally, we have the following preferred stock:
dividend  7%
par value  $100
price  $85
The dollar dividend for this stock is 7% of the par value, or (7%)  ($100)  $7. Given the
$7
price of $85, this implies a required return of ( $85 )  8.24%.

14-7. If Boston Brewery is issuing new common equity, and if its stock grows at a constant rate, then we
can find its kcs using equation 14-3a:
D1 D* (1  g)
kcs  g 0  g.
P0 P0
Substituting with Boston Brewery’s values, we find:
kcs = [$1.45 * (1.05)]/$13 + 0.05 = 11.71% + 5% = 16.71%.
Thus, Boston Brewery’s equity investors require a 16.71% return to compensate them for the risk
of holding Boston Brewery’s stock. Boston Brewery provides this return through an
11.71%dividend yield and a 5% dividend growth rate.

14-8. If Falon Corporation is issuing new common equity, and if its stock grows at a constant rate, then
we can find its kcs using equation 14-3a:
D1 D* (1  g)
kcs  g 0  g.
P0 P0
Substituting with Falon’s values, we find:

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358  Titman/Keown/Martin  Financial Management, Thirteenth Edition
$1.30 * (1.07)
kcs   0.07  4.97%  7%  11.97%.
$28.00
Thus Falon’s equity investors require an 11.97% return to compensate them for the risk of holding
Falon’s stock. Falon provides this return through a 4.97% dividend yield and a 7% dividend growth
rate.
14-9. Temple-Midland’s new bond has the following characteristics:
par value  $1000
coupon rate  8%
market value  $950
maturity (years)  15
marginal tax rate  35%
Using equation 9-2c, we can solve for the semi-annual yield to maturity (YTM, or i) we get
4.2998%. The annual YTM is (4.2998%)*(2) = 8.60%. Of course, we can also solve for YTM
using Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(15*2, 80/2, 950, 1000)  rate  4.2998%.
Again, note that this rate is YTM/2, implying that the YTM is (4.2998%)*(2) = 8.60%. It is not
surprising that this bond’s YTM is greater than its coupon rate, since the bond is selling at a
discount.

With a 8.60% YTM, we find the effective after-tax cost for Temple-Midland’s bond to be
(8.60%)  (1  0.35)  5.59%

14-10. Belton Distribution Company’s new bond has the following characteristics:
par value  $1000
coupon rate  7%
market value  $958
maturity (years)  15
marginal tax rate  18%
Using equation 9-2c, we can solve for the semi-annual yield to maturity (YTM, or i) as follows:

$958 = (7%/2)*($1000)*{[1 – 1/(1 + i)30]/i + $1000/(1 + i)30 → i = 3.7351%,

The annual YTM is (3.7351%)*(2) = 7.47%. Of course, we can also solve for YTM using Excel’s
RATE function:
 RATE(nper, pmt, PV, FV)   RATE(15*2, 70/2, 958, 1000)  rate  3.7351%.
Again, note that this rate is YTM/2, implying that the YTM is (3.7351%)*(2) = 7.47%. It is not
surprising that this bond’s YTM is greater than its coupon rate, since the bond is selling at a
discount.

With a 7.47% YTM, we find the effective after-tax cost for Belton’s bond to be (7.47%) 
(1  0.18)  6.13%.

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 Solutions to End-of-Chapter Problems—Chapter 14 359
14-11. Walter Industries has the following preferred stock:
dividend  $2.50
price  $36
Using equation 14-2a, we know that:
 div ps 
k ps    .
 price
 ps 
Thus for Walter, we have:
 $2.50 
k ps     6.94%.
 $36.00 
Investors require a 6.94% return for preferred stock of this risk class.

14-12. Gator Industries has the following preferred stock:

dividend  $2.75
price  $35
Using equation 14-2a, we know that:
 div ps 
k ps    .
 price ps
 
Thus for Gator, we have:
 $2.75 
k ps     7.86%.
 $35.00 
Investors require a 7.86% return for preferred stock of this risk class.
If Gator were to issue 500,000 more shares, with a flotation cost of $3/share, its total flotation cost
would be:
total flotation cost  ($3/share)  (500,000 new shares)  $1.5 million.
$3
(This is 8.57% of the desired proceeds of $17.5 million, since ( $35 )  0.0857.) To incorporate
these flotation costs into a net present value calculation, Gator must recognize that the costs
attributed to the project must include the $1.5 million in flotation costs for the preferred equity.
The NPV of the project will therefore be $1.5 million lower than it would be without these costs.
If Gator uses the proceeds from the sale of the 500,000 shares to pay the flotation costs, then it
will only raise ($17.5 million  $1.5 million)  $16 million  ($35  $3)  (500,000) for its
project. The analysis above assumes that this is sufficient. However, if the firm needs $17.5 million
in net proceeds, then it will have to sell more than 500,000 shares:
net proceeds  $17.5 million  ($32/share)  (# of shares)  # of shares  546,875,
which implies gross proceeds of (546,875)  ($35)  $19,140,625.
Note that we can verify this using equation 14-6:
financing needed

(1  flotation %)
flotation-cost adjusted initial outlay
$17,500,000
  $19,140,625.
(1  0.0857)

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360  Titman/Keown/Martin  Financial Management, Thirteenth Edition
In this case, the flotation costs in dollars are ($19,140,625  $17,500,000)  $1,640,625  ($3/share)
 (546,875). Choosing the larger issue would mean that Gator’s NPV would fall by an extra
($1,640,625  $1,500,000)  $140,625  ($3)  (46,875) (all else equal).1

14-13. Shiloh Corporation’s new bond has the following characteristics:

par value  $1000
coupon rate  13%
market value  $950
maturity (years)  15
marginal tax rate  34%
Using equation 9-2c, we can solve for the yield to maturity (YTM, or i) as follows:

$950 = (13%/2)*($1000)*{[1 – 1/(1 + i)30]/i + $1000/(1 + i)30 → i = 6.8988%,

so that the annual YTM is (6.8988%)*(2) = 13.80%. Of course, we can also solve for YTM using
Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(15*2, 130/2, 950, 1000)  rate  6.8988%.
Again, note that this rate is YTM/2, implying that the YTM is 6.8988%*(2) = 13.80%. It is not
surprising that this bond’s YTM is greater than its coupon rate, since the bond is selling at a
discount.
With a 13.80% YTM, we find the effective after-tax cost for Shiloh’s bond to be (13.80%)  (1  0.34)
 9.11%.

14-14. For our preferred stock, we have:

Market Value $98.00

Par Value $100.00
Dividend Rate 10.00%

First, we need to find the dividend amount. Since the preferred pays 10% of par, it must pay
(10%)  ($100)  $10/year. Given the current stock price of $98, this implies a required return of
($10/$98) = 10.2%. (Note that this is more than the dividend rate of 10%, since the preferred stock’s
price is less than par.)
Note that we have used equation 14-2a here:
kps = (divps/priceps) = ($10/$98) = 10.2%
14-15. Oxford, Inc.’s common equity has the following characteristics:
dividend paid last year  $1.80
constant growth in dividends, per year  4%
current stock price  $22.50

1
The numbers above are rounded. The actual percentage, to three more decimal places, is 8.57143%.

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 Solutions to End-of-Chapter Problems—Chapter 14 361

Since Oxford’s stock grows at a constant rate, then we can find its kcs using equation 14-3a:
D1 D* (1  g)
kcs  g 0  g.
P0 P0
$1.80  (1.04)
  0.04  8.32%  4%  12.32%.
$22.50
Thus Oxford’s equity investors require a 12.32% return to compensate them for the risk of holding
Oxford’s stock. Oxford provides this return through an 8.32% dividend yield and a 4% capital
gains yield.

14-16. Kingsford Corporation’s common equity has the following characteristics:

Last year dividend $4.00

Market price of stock $58.00
Marginal Tax rate 22%
Dividend growth rate 4%

Since Kingsford’s stock grows at a constant rate, then we can find its kcs using equation 14-3a:
D1 D* (1  g)
kcs  g 0 g
P0 P0
$4.00  (1.04)
  0.04  7.17%  4%  11.17%.
$58.00
Thus, Kingsford’s equity investors require an 11.17% return to compensate them for the risk of
holding Kingsford’s stock. Kingsford provides this return through a 7.17% dividend yield and a
4% dividend growth rate.
Note that we did not need the firm’s marginal tax rate to determine its cost of equity. Unlike debt,
equity has no tax advantages for issuers: equityholders are paid after taxes. Thus, Kingsford must
bear the full 11.17% cost of its equity (but only the after-tax cost of its debt).

14-17. We have the following information about M & M Corporation’s stock:

Last year dividend $2.75

Market price of stock $50.00
Beta of the stock 1.25
Market risk premium 5%
Risk free rate 4.00%
Dividend 5 yrs ago $2.10

a. If we assume that the $2.10 dividend came at t  5 and last year’s dividend was at t  0, then
our time line looks like this:
D5  $2.10 D0  $2.25 D1  ?
| | | | | | |
5 4 3 2 1 0 1

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362  Titman/Keown/Martin  Financial Management, Thirteenth Edition
In order to find M & M’s cost of equity using the dividend discount model, we need to have
D1, the dividend to be paid one period from now. In turn, this requires that we know the rate of
constant growth, g. Given that the firm has been in constant growth throughout our period, we
can find g as follows:
D0 = D*5 (1  g)5
$2.25  $2.10 (1  g)5
($2.25/$2.10)  (1  g)5
1.071  (1  g)5
(1.071)1/5  (1  g)
1.01389  (1  g)  g  1.39%.
Thus we can find D1 as:
D1  D0 (1  g)1
*

D1  $2.25  (1.01389)  $2.28.

Now, using equation 14-3a, we can find M & M’s cost of common equity as:
Kcs= $2.28/$60 + 0.01389
kcs = 3.8% + 1.39% = 5.19%.
b. Because the cost of common stock is so difficult to estimate, analysts often use multiple
methods in their analysis. If we want to find another estimate for M & M’s cost of common
stock using the CAPM, we would apply equation 14-4:
kcs  rf  cs* [rm  rf ]
 rf   cs* [market risk premium].

Using the values given for M & M Corporation, we have:

kcs  4.0%  [(0.80)  (5%)]  8.0%,
which is 281 bp higher than our earlier estimate.
Note that M & M’s CAPM kcs estimate is less than the expected return on the market (which is
4.0%  [1  (5%)]  9.0%since M & M’s beta is less than 1 (the beta of the market, and the
average beta for all assets). Assets with the market’s level of risk (  1) are entitled to (or their
investors demand from them) the full 5% market risk premium. M & M Corporation, on the
other hand, is slightly defensive, and therefore need not offer the full 5% market risk premium.
Because M & M Corporation is less volatile than average, investors require only [(0.80) 
(5%)]  4% above the risk-free rate in compensation for its (lower) risk.

14-18. Gillian Stationery Corporation wishes to raise $600,000 for a project. It will issue bonds with the
following characteristics:
par value  $1000
coupon rate  8%
YTM  10%
maturity (years)  10

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 Solutions to End-of-Chapter Problems—Chapter 14 363
a. To determine how many of these bonds Gillian will need to issue, we first need to determine
the price for which each $1000 par-value bond can be sold. Using the bond pricing model from
equation 9-2c, we have:

price = (8%/2)*($1000)*{[1 – 1/(1 + 0.05)20]/0.05 + $1000/(1.05)20

price = $498.49 + $376.89 = $875.38

The bonds will sell for less than par (a discount), since investors’ required return, 10%, is greater
than the bonds’ coupon rate, 8%.
b. If Gillian wishes to raise $600,000, it will therefore need to issue at least ($600,000/$875.38)
= 686 bonds bonds
since the ratio is actually 685.42.
c. Given Gillian’s marginal tax rate of 34%, its after-tax cost on these bonds will be (10%) 
(1  0.34)  6.60%.

14-19. Sincere Stationery Corporation wishes to raise $500,000 for a project. It will issue bonds with the
following characteristics:
par value  $1000
coupon rate  10%
YTM  9%
maturity (years)  10
a. To determine how many of these bonds Sincere will need to issue, we first need to determine
the price for which each $1000 par-value bond can be sold. Using the bond pricing model
from equation 9-2c, we have:

price = (10%/2)*($1000)*{[1 – 1/(1 + 0.045)20]/0.045 + $1000/(1.045)20

price = $650.40 + $414.64 = $1065.04

The bonds will sell for more than par (a premium), since investors’ required return, 9%, is
lower than the bonds’ coupon rate, 10%.
b. If Sincere wishes to raise $500,000, it will therefore need to issue ($500,000/$1065.04) = 470
bonds since the ratio is actually 469.47.
c. Given Sincere’s marginal tax rate of 34%, its after-tax cost on these bonds will be (9%) 
(1  0.34)  5.94%.

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364  Titman/Keown/Martin  Financial Management, Thirteenth Edition
14-20. Using Figure 14.3 we find that the spread to Treasury for a 30-year AA bond is 3.83%, for a total
yield of the Treasury rate plus 3.83%.

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 Solutions to End-of-Chapter Problems—Chapter 14 365
14-21. Tellington is going to issue a 10-year maturity bond at about an 8.5% nominal rate of return.
Using Figure 14.3, as below, we note that the U.S. Treasury rate for a 10-yr bond is 1.59%. If we
then subtract 1.59% from 8.5% we then get an expected spread to Treasury rate of 6.91%. We
now locate the values that brackets 6.91% in the 10-year column of figure 14.3. We find that BB-
bonds have a spread to Treasury rate of 6.42% and that of the B+ bonds are 7.26%. We therefore
conclude that the probably rating of the bond is either BB- or B+.

14-22. To determine QM Industries’ WACC, we use equation 14-1:

WACC  kd* wd  kcs* wcs  k *ps w ps ,

where we have added a third term for preferred stock, and where we interpret k d as the after-tax
cost of debt.
18%

16%

14%

12%

40%
10%
common stock
18.00%
8%
50% preferred stock
debt

6%

10.00%
4%

5.20%
2%
10%
0%
common stock preferred stock debt

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366  Titman/Keown/Martin  Financial Management, Thirteenth Edition
Thus to find WACC, we need both the weights and the costs for each of QM’s three funding sources.
We were given the weights as 40% common, 50% debt, and 10% preferred. We were also given
the pre-tax costs of 18%, 8%, and 10%, respectively. The one thing we need to do here is to find
the after-tax cost of debt: (8%)  (1  0.35)  5.2%. Now we have all of our inputs:
To find WACC, we can now just plug our inputs into equation 14-1. A spreadsheet approach to this
is shown below (comparable to the approach shown in Checkpoint 14.1):
tax rate = 35%
A B C D = A*C
before-tax after-tax
capital structure component component weighted
weights costs costs after-tax cost
common stock 40% 18.00% 18.00% 7.20%
preferred stock 10% 10.00% 10.00% 1.00%
debt 50% 8.00% 5.20% 2.60%
100% = (8%)*(1-.35) 10.80% WACC
QM’s weighted average cost of funds is 10.8%, between the after-tax costs of its debt (the lowest-
cost source of funds) and its common stock (the highest-cost source). Thus QM’s projects must
earn more than 10.8% to be profitable.
14-23. Silver Steel Company uses two funding sources: debt and equity. Forty percent of its assets are
financed with debt, which has a pretax cost of 6% The other 60% of its assets are financed with
equity, whose investors require a 15% return. To find Silver Steel’s WACC, we must find the
after-tax cost of these funding sources (that is a consideration for debt—since the after-tax cost of
equity is the same as its pretax return), and then average them by weighting the costs by their
relative importance. The spreadsheet below illustrates the process:
tax rate = 40%
A B C D = A*C
before-tax after-tax
capital structure component component weighted
weights costs costs after-tax cost
common stock 60% 15.00% 15.00% 9.00%
debt 40% 6.00% 3.60% 1.44%
100% = (6%)*(1-0.40) 10.44% WACC
Silver Steel’s WACC is 10.44%, which is between its 15% cost of common stock and its 3.60%
after-tax cost of debt. Silver Steel should not invest in any project of average risk whose return is
less than 10.44%.
14-24. To find Crypton Electronic’s WACC, we first must find the costs of capital for its funding
sources, debt and common stock.
Its debt has the following characteristics:
pa value  $1000
coupon rate  6%
market value  $975
maturity (years)  15
marginal tax rate  30%
Using equation 9-2b, we can solve for the yield to maturity (YTM, or i) as follows:

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 Solutions to End-of-Chapter Problems—Chapter 14 367

1  1
(1 i )15
 $1000
$975  (6%)  ($1000)     i  6.26%
i  (1  i )
15

(Note that the bond makes annual interest payments.) Of course, we can also solve for YTM using
Excel’s RATE function:
 RATE(nper, pmt, PV, FV)   RATE(15, 60, 975, 1000)  rate  6.26%.
The YTM on Crypton’s debtis greater than its coupon rate of 6%, since the bonds sell at a
discount.
Given the 6.26% before-tax cost of debt, we find Crypton’s after-tax cost of debt as (6.26%) 
(1  0.30)  4.382%. This is the effective cost to the firm of the 60% of its assets that it finances
with debt.
To find the cost of Crypton’s common stock, we use equation 14-3a:
D1
kcs  g
P0
$2.25
  0.05
$30.00
 7.50%  5%  12.50%.
Crypton’s stock offers a 7.5% dividend yield (calculated as the ratio of its projected dividend for
next year, $2.25, to its current stock price, $30) and its 5% dividend growth rate (the rate of
sustainable growth in Crypton’s stock). Thus, the firm pays 12.5% on the 40% of its assets that it
finances with equity.
Now that we have the after-tax costs for both of Crypton’s funding sources, we can find its WACC as
follows:
13%

11%

9%

40%
7%

12.50% common stock

debt
5%

60%
3%

4.38%

1%

common stock debt

-1%

We can now find Crypton’s WACC as follows:

tax rate = 30%

A B C D = A*C
before-tax after-tax
capital structure component component weighted
weights costs costs after-tax cost
common stock 40% 12.50% 12.50% 5.00%
debt 60% 6.26% 4.38% 2.63%
100% = (6.26%)*(1-.30) 7.63% WACC

Crypton’s WACC is 7.63%, between its after-tax cost of debt and its cost of equity. Crypton
should not accept any project of average risk whose return is less than 7.63%.

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368  Titman/Keown/Martin  Financial Management, Thirteenth Edition
14-25. J & J Manufacturing uses common stock, preferred stock, and debt to finance its assets. The
weights of each are shown in the graph on the right below. The graph on the left below gives the
firm’s costs for these funding sources. Note that the pre-tax cost of debt is 5%, which translates
into (5%)  (1  0.22)  3.90% after tax, given the firm’s 22% marginal tax rate.
Given these weights and after-tax costs, we can find J & J’s WACC as follows:
tax rate = 22%
A B C D = A*C
before-tax after-tax
capital structure component component weighted
weights costs costs after-tax cost
common stock 50% 15.00% 15.00% 7.50%
preferred stock 15% 9.00% 9.00% 1.35%
debt 35% 5.00% 3.90% 1.37%
100% = (5%) *(1-0.22) 10.22% WACC
The firm’s WACC is 10.22% J & J should not accept projects of average risk whose returns are
less than 10.22%.
14-26. To find Bane Industries’ WACC, we first need to find its after-tax costs of common stock and
debt. We’ll start with debt, for which we have the following details:
par value  $1000
coupon rate (paid semiannually)  8%
market value  $1100
maturity (years)  20
marginal tax rate  34%
To find the YTM for this new debt issue, we use equation 9-2c, which accounts for semiannual
compounding:
 1  (1 YTM
1
)2 n
  1 
price  (interest/2)   2
  principal   YTM 2 n 
.
 (1  2 ) 
YTM
 2 

Substituting Bane’s values, we have:

 1  (1 YTM
1

$1100  ($80 / 2)   YTM2   $1000   (1 YTM .
)40 1

 2   2 )40 

Solving for YTM, we find that Bane’s before-tax cost of debt is 3.53% semiannually, which when
multiplied by 2 yields an annual rate of 7.06%. We could also have found this using Excel’s RATE
function:
RATE(nper, pmt, PV, FV)  RATE(20  2, 80/2, 1100, 1000)  rate  3.53%.
This rate is YTM/2, implying that the YTM is (3.53%)  (2)  7.06%. This is less than the bond’s
coupon rate, which leads to the premium price.
Bane’s after-tax cost of debt, given its YTM of 7.06%, is (7.06%)  (1  0.34)  4.66%.
Now we find Bane’s cost of common equity, using equation 14-3a:

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 Solutions to End-of-Chapter Problems—Chapter 14 369
D1
kcs  g
P0
$2.00
  0.08
$80.00
 2.50%  8%  10.50%.
Now that we have the components’ costs, we can weight them to find WACC:
13%

11%

9%

40%
7%
common stock
debt
5%
10.50%

60%
3%

4.66%

1%

common stock debt

-1%

tax rate = 34%

A B C D = A*C
before-tax after-tax
capital structure component component weighted
weights costs costs after-tax cost
common stock 60% 10.50% 10.50% 6.30%
debt 40% 7.06% 4.66% 1.86%
100% = (7.06%)*(1-.34) 8.16% WACC

Bane’s WACC is 8.16%, between its after-tax cost of debt and its cost of equity. Bane should not
accept any projects of average risk whose returns are less than 8.16%.
14-27. To determine the WACC for Ranch Manufacturing, we will first find the component costs of
capital. First, we’ll look at Ranch’s bonds, which have the following characteristics:
Market Value of Common stock $6,000,000.00
Market Value of Debt $4,000,000.00
Market Value of preferred stock $2,000,000.00
Market price of preferred stock $25.00
Dividend of preferred stock $2.00
Face value $1,000.00
Market Value of bond $1,050
Number of years 10
Coupon rate 7%
Compounding periods/year 2
Dividend growth rate 5%
Tax rate 30%
Market value of stock $55
Dividend last year $3.00
Using equation 9-2c, we can solve for the yield to maturity (YTM, or i) as follows:

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370  Titman/Keown/Martin  Financial Management, Thirteenth Edition
$1050 = (7%/2)*($1000)*{[1 – 1/(1 + i)20]/i + $1000/(1 + i)20 → i = 3.16%,
so that the YTM is (3.16%)*(2) = 6.32%.Of course, we can also solve for YTM using Excel’s
RATE function:
 RATE(nper, pmt, PV, FV)  RATE(10*2, 70/2, 1050, 1000) rate  3.16%.
This rate is YTM/2, implying that the YTM is (3.16%)*(2) = 6.32%. (It is not surprising that this
bond’s YTM is less than its coupon rate, since the bond is selling at a premium.) On an after-tax
basis, Ranch would pay (6.32%)  (1  0.30)  4.42% for these bonds.
For the firm’s preferred stock, we use equation 14-2a:
div ps $2.00
k ps    8%
price ps $25.00

Note that the cost of preferred stock is greater than the cost of debt, as we would expect: preferred
stock has greater risk than debt.
Finally, for the firm’s constant-growth stock, we can find kcs using equation 14-3a as:
D1 D* (1  g)
kcs  g 0  g.
P0 P0
$3.00  (1.05)
  0.05  5.73%  5%  10.73%.
$55.00

The cost of common stock is the greatest of all, since this residual claim has the greatest risk.
Now that we have the costs, we can find the weights. We were given the market values for each of
the three funding sources, which determine their relative importance in Ranch’s capital structure.
Their weights are simply the proportion of total market value contributed by each funding source:
market capital structure
value weights notes
common stock $6,000,000 50% =$6 mil./$12 mil.
preferred stock $2,000,000 17% = $2 mil./$12 mil.
bonds $4,000,000 33% =$4 mil./$12 mil.
$12,000,000 100%
Thus, Ranch Manufacturing gets half of its funding from stock, one-third from bonds, and the balance
(17%) from preferred stock.
Here is Ranch’s overall situation:
11%

9%

33% 7%

common stock 10.73%

5%
50% preferred stock
bonds 8.00%

3%

4.42%

1%

17%
common stock preferred stock bonds
-1%

We can now use equation 14-1 to combine this information into WACC:

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 Solutions to End-of-Chapter Problems—Chapter 14 371
WACC  k wd  k wcs  k *ps w ps
*
d
*
cs

(where we have added a third term for preferred stock, and where we interpret kd as the after-tax
cost of debt). We use the spreadsheet below to accomplish this:
tax rate = 30%
A B C D E = B*D
before-tax after-tax
market capital structure component component weighted
value weights costs costs after-tax cost
common stock $6,000,000 50% 10.73% 10.73% 5.36%
preferred stock $2,000,000 17% 8.00% 8.00% 1.33%
bonds $4,000,000 33% 6.32% 4.42% 1.47%
$12,000,000 100% =(6.32%)*(1-0.30) 8.17% WACC

Ranch’s WACC is 8.17%, between its after-tax cost of debt of 4.42% (its lowest-cost funding
source) and its cost of common stock of 10.73% (its highest-cost source). Ranch should not accept
any projects (of average risk) whose returns are less than 8.17%.
14-28. To determine the WACC for Lulu Athletic Clothing Company, we will first find the component
costs of capital. First, we’ll look at Lulu Athletic Clothing Company’s bonds, which have the
following characteristics:
Market Value of Common stock $400,000.00
Market Value of Debt $500,000.00
Market Value of preferred stock $100,000.00
Market price of preferred stock $35.00
Dividend of preferred stock $2.50
Face value $1,000.00
Market Value of bond $1020
Number of years 20
Coupon rate 6%, paid semiannually
Compounding periods/year 2
Dividend growth rate 4%
Tax rate 34%
Market value of stock $50
Dividend last year $4.00
Using equation 9-2c, we can solve for the yield to maturity (YTM, or i) as follows:

$1020 = (6%/2)*($1000)*{[1 – 1/(1 + i)40]/i + $1000/(1 + i)40 → i = 2.915%, so that the YTM
is (2.915%)*(2) = 5.83%. Of course, we can also solve for YTM using Excel’s RATE function:
RATE(nper, pmt, PV, FV)  RATE(20*2, 60/2, −1020, 1000)  rate  2.915%.
This rate is YTM/2, implying that the YTM is (2.915%)*(2) = 5.83%. (It is not surprising that this
bond’s YTM is greater than its coupon rate, since the bond is selling at a discount.) On an after-tax
basis, Lulu Athletic Clothing Company would pay (5.83%)  (1 )  3.85% for these bonds.
For the firm’s preferred stock, we use equation 14-2a:
kps = (divps/priceps) = ($2.50/$35.00) = 7.14%.
Note that the cost of preferred stock is greater than the cost of debt, as we would expect: Preferred
stock has greater risk than debt.

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372  Titman/Keown/Martin  Financial Management, Thirteenth Edition
Finally, for the firm’s constant-growth stock, we can find kcs using equation 14-3a as:
kcs= [$4.00 * (1.04)]/$50 + 0.04 = 8.32% + 4% = 12.32%.
The cost of common is the greatest of all, since this residual claim has the greatest risk.
Now that we have the costs, we can find the weights. We were given the market values for each of
the three funding sources, which determine their relative importance in LACC’s capital structure.
Their weights are simply the proportion of total market value contributed by each funding source:
market capital structure
value weights notes
common stock $500,000 50% = $0.5 mil./$1 mil.
preferred stock $200,000 20% = $0.2 mil./$1 mil.
bonds $300,000 30% = $0.3 mil./$1 mil.
$1,000,000 100%
Thus, Lulu Athletic Clothing Company gets 50% of its funding from stock, 30%from bonds, and
the balance (20%) from preferred stock.
We can now use equation 14-1 to combine this information into WACC:
WACC  kd* wd  kcs* wcs wcs  k ps
*
w ps , WACC = kd*wd + kcs*wcs + kps*wps,

(where we have added a third term for preferred stock, and where we interpret kd as the after-tax
cost of debt). We use the spreadsheet below to accomplish this:
tax rate = 34%
A B C D E = B*D
before-tax after-tax
market capital structure component component weighted
value weights costs costs after-tax cost
common stock $500,000 50% 12.32% 12.32% 6.16%
preferred stock $200,000 20% 7.14% 7.14% 1.43%
bonds $300,000 30% 5.83% 3.85% 1.15%
$1,000,000 100% = (5.83%)*(1-0.34) 8.74% WACC

Lulu Athletic Clothing Company’s WACC is 8.74%, between its after-tax cost of debt of 3.85% (its
lowest-cost funding source) and its cost of common stock of 12.32% (its highest-cost source).
LACCshould not accept any projects of average risk whose returns are less than 8.74%. Thus,
assuming the new warehouse project is a project of average risk, LACC should use a 8.74%
discount rate when finding the net present value of the warehouse. If the project’s NPV is positive,
it should be undertaken.
14-29. Faraway Moving Company has a $200 million project that will require $50 million in debt. The
flotation costs on this debt are 200 basis points, or 2% (since there are 100 basis points in one
percentage point). If the firm wishes to include the flotation costs in its debt offer, leaving enough
—after paying its investment banker—to fund the project, it must borrow more than just $50
million. In fact:
$50 million  amount borrowed  flotation costs
$50 million  amount borrowed  (2%)  (amount borrowed)
$50 million  amount borrowed  (1  0.02)
 $50M 
 1  0.02   amount borrowed  $51,020,408.
 

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 Solutions to End-of-Chapter Problems—Chapter 14 373

Faraway must borrow $51,020,408 in order to net $50,000,000 for its expansion. (Note that 2%
of this amount is (0.02)  ($51,020,408)  $1,020,408, exactly the amount the firm borrows above
the $50 million it needs for expansion.) The total cost of the expansion is therefore ($150,000,000
 $51,020,408)  $201,020,408.
Note that the equation we used above is equation 14-6:
financing.needed
flotation-cost adjusted initial outlay 
(1  flotation %)
14-30. If Pandora Internet Radio Company wants to issue enough common stock to fund a $75 million
expansion, after paying 15% flotation costs, then Pandora must initially issue more than $75M
worth of stock. In fact:
$75 million  amount issued – flotation costs
$75 million  amount issued – (15%)  (amount issued)
$75 million  amount issued  (1  0.015)
 $75M   amount issued  $88,235,294.
 1  0.15 
 

Pandora must issue $88,235,294 in order to net $75,000,000 for its expansion. (Note that 15% of
this amount is (0.15)  ($88,235,294)  $13,235,294, exactly the amount the firm issues above the
$75 million it needs for expansion.)
Note that the equation we used above is equation 14-6:
financing needed
flotation-cost adjusted initial outlay  .
(1  flotation.%)

14-31. Let’s assume the following:

(1) The $10 million that Two-Foot Tools borrowed was the net amount, after paying the
investment banker’s 1.5% fee.
(2) The distribution facility will cost $20 million, so the firm will finance it with the $10 million it
borrowed, plus $10 million from retained earnings.
(3) The total initial outlay for the plant expansion will therefore be the $20 million for the project,
plus the fee paid for the debt issue.
Given these assumptions, we can use equation 14-6 to determine the gross amount of debt that
Two-Foot had to issue:
financing.needed

(1  flotation %)
flotation-cost adjusted initial outlay $10,000,000

 1  .015 
 $10,152,284
Two-Foot’s total outlay for the project was ($20,000,000  $ 152,284)  $ 20,152,284.

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