CHAPTER 9

SOLUTIONS TO PROBLEMS: P9-1, 9-4, 9-7, 9-9, 9-11, 9-12, 9-15, 9-16, 9-19, 9-21

NOTE: Shortly after the first press run for the 15th edition, the US Congress passed the Tax Cuts and
Jobs Act of 2017, which included changes in the corporate tax rate relevant to this chapter. In subsequent
printing runs, the text was updated to reflect the new tax law, but these updates may not appear in every
student’s copy of the text. Accordingly, solutions to the following problems were modified to include
answers based on the old and new US corporate income tax rate: P9-4, P9-19.

P9-1 Concept of cost of capital (LG 1; Basic)

a. Project North is expected to earn an 8% return. If the analyst expects the cost of debt to
be 7%, she will recommend accepting the project because the expected return exceeds
financing cost.
b. Project South is expected to earn 15%, but financing (retained earnings) costs 16%. So,
the analyst will recommend rejecting the project because financing cost exceeds
expected return.
c. These decisions may not enhance shareholder wealth because the firm finances
investments with a blend of debt and equity. The proper “hurdle rate” for projects should
reflect the cost of the blend (i.e., weighted average cost of capital), not the cost of debt
or equity alone.
d. The weighted average cost of capital (rwacc) is given by (wd rd) + (ws  rs), where rd is
the before- and after-tax cost of debt, wd the weight of debt in the firm’s capital
structure, ws the weight of equity in the capital structure, and rs the required return on
equity. Here, wd is given as 40%, rd as 7%, ws as 60%, and rs as 60%, so rwacc = (0.4 ×
7%) + (0.6 × 16%) = 12.4%.
e. If the hurdle rate for both projects were 12.4%, the first analyst would recommend
rejecting project North, and the second analyst would recommend accepting Project
South.
f. The proper “hurdle rate” will reflect the weights associated with the target capital
structure. The cost of equity is considerably higher than the cost of debt while the
weighted average cost of capital lies in between. Evaluating projects with the cost of
debt alone will result in accepting projects that diminish firm value. Similarly,
evaluating projects with the cost of equity alone will result in rejecting some projects
that would have added value to the firm.
P9-4 Cost of debt using the approximation formula (LG 3; Basic)

$1,000  N d After-tax cost of debt rd  (1T)

I
rd  n where:
N d  $1,000 rd = pre-tax cost of debt
2 Nd = Net proceeds from bond sale
n = number of years to maturity
I = Annual interest payments in dollars.

Bond A Bond D
$1,000  $955 $1,000  $985
$90  $90 
20 $92.25 25 $90.60
rd    9.44% rd    9.13%
$955  $1,000 $977.50 $985  $1,000 $992.50
2 2
After-tax cost of debt (40% tax rate):
After-tax cost of debt (40% tax rate):
 9.13%  (10.40)  5.48%
 9.44%  (10.40)  5.66%
After-tax cost of debt (21% tax rate):
After-tax cost of debt (21% tax rate):
 9.13%  (10.21)  7.21%
 9.44%  (10.21)  7.46%
Bond E
Bond B
$1,000  $920
$1,000  $970 $110 
$100  22 $113.64
16 $101.88 r    11.84%
rd    10.34% d $920  $1,000 $960
$970  $1,000 $985
2
2
After-tax cost of debt (40% tax rate):
After-tax cost of deb (40% tax rate):
 11.84%  (10.40)  7.10%
 10.34%  (10.40)  6.20%
After-tax cost of debt (21% tax rate): After-tax cost of debt (21% tax rate):
 10.34%  (10.21)  8.17%  11.84%  (10.21)  9.35%
Bond C
$1,000  $955
$120 
15 $123
rd    12.58%
$955  $1,000 $977.50
2
After-tax cost of deb (40% tax rate):
 12.58%  (10.40)  7.55%
After-tax cost of debt (21% tax rate):
 12.58%  (10.21)  9.94%
P9-7 Cost of preferred stock (LG 4; Basic)
The cost of preferred stock is given by rp  Dp  Np, where Dp is annual preferred dividends
(in dollars) and Np is net proceeds from issuing preferred stock.
a. Np = Sales price – Flotation costs = $98.50 – $3.00 = $95.50. Given an 6% annual
dividend ($6),
rp = $6 $
b. Np is now given as $93. Given an 10% annual dividend ($10), rp = $10
$

P9-9 Cost of common stock equity: CAPM (LG 5; Intermediate)

According to CAPM, the required return on asset j is given by RF  [ j(rm  RF)], where j
is the beta for asset j, RF is the risk-free rate, and rm is the expected return on the market
portfolio.
rs RF  [b × (rm RF)]
rs 5%  1.8 × (16% 5%)
rs 5% 19.8%
rs  24.8%
a. Risk premium 19.8%
b. Rate of return 24.8%
c. Cost of common equity using the CAPM 24.8%

P9-11 Retained earnings versus new common stock (LG 5; Intermediate)

The cost of retained earnings is simply the required return on common stock (rs):
𝐷1
𝑟𝑠 = +g
𝑃0
where: D1 = Next annual dividend payment in dollars
P0 = Current price of common stock
g = Dividend growth rate
And the cost of common stock is given by:
𝐷1
𝑟𝑛 = +g
𝑁𝑛
where: D1 = Next annual dividend payment in dollars
Nn = Net proceeds from issue of common stock
g = Dividend growth rate
So, the cost of returned earnings and common stock for firms A, B, C, and D are:

Column 1 2 3 4 5 6= 7= 8=
1-4-5 (3/1) +2 (3/6) +2
Firm P0 g D1 Under- Flotation Net Cost of Cost of
pricing cost proceeds Retained Common
per share Earnings Stock
 A $50.00 8% $2.25 $2.00 $1.00 $47.00 12.5% 12.79%
B $20.00 4% 1.00 0.50 1.50 $18.00 9.00% 9.56%
C $42.50 6% 2.00 1.00 2.00 $39.50 10.71% 11.06%
D $19.00 2% 2.10 1.30 1.70 $16.00 13.05% 15.13%

P9-12 Effect of tax rate on WACC (LG 3, LG 4, LG 5, and LG 6; Intermediate)

Weighted average cost of capital: rwacc = [wd rd)] + (wp  rp) + (ws  rs), where
wd is the weight of debt in the firm’s capital structure, T is the firm’s tax rate, rd is the
before-tax cost of debt, wp the weight on preferred stock, rp the cost of preferred stock,
ws the weight on common stock, and rs the cost of common stock. Given wd = 40%, rd =
6%, wp = 10%, rp = 8%, ws = 50%, and rs = 10%:
a. And a tax rate of 40%, rwacc = (0.40)(0.06)(1  0.40)  (0.10)(0.08)  (0.50)(0.10) =
7.24%.
b. And a tax rate of 35%, rwacc = (0.40)(0.06)(1  0.35)  (0.10)(0.08)  (0.50)(0.10) =
7.36%.
c. And a tax rate of 25%, rwacc = (0.40)(0.06)(1  0.25)  (0.10)(0.08)  (0.50)(0.10) =
7.60%.
d. The weighted-average cost of capital rises as the tax rate falls. The deductibility of
interest expense is a form of government subsidy. Lower tax rates mean smaller
subsidies and a higher cost of debt and long-term capital overall.

P9-15 Weighted average cost of capital and target weights (LG 6; Intermediate)
a. Weighted average cost of capital (rWACC) with historical market weights:
Column → 1 2 3=1x2
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.25 4.20% 1.05%
Preferred stock 0.1 9.50% 0.95%
Common equity* 0.65 13.00% 8.45%
1.00 Sum (r WACC) = 10.45%
b. Weighted average cost of capital (rWACC) with target market weights:
Column → 1 2 3=1x2
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.30 4.20% 1.26%
Preferred stock 0.15 9.50% 1.43%
Common equity* 0.55 13.00% 7.15%
1.00 Sum (r WACC) = 9.84%
*The firm has plenty of retained earnings available to finance new projects, so the cost
of common equity is the cost of retained earnings (13%), not the cost of new common
stock (15%)
c. Weighted average cost of capital is lower in part (b) because more weight is placed on
cheaper sources of capital (debt and preferred stock) and less on the costliest source
(common stock).
P9-16 Cost of capital (LG 3, LG 4, LG 5, and LG 6; Challenge)
a. Cost of retained earnings:
D1 D1 (1+𝑟)
rs = P0
+g= P0
+ g

0.80 × (1 + 0.08)
𝑟𝑟 = + 0.08 = 0.32 𝑜𝑟 32%
3.60
b. Cost of new common stock:
0.80 × (1 + 0.08)
𝑟𝑠 = + 0.08 = 0.35 𝑜𝑟 35%
3.60 − 0.40
c. Cost of preferred stock:
1
𝑟𝑝 = = 0.1064 𝑜𝑟 10.64%
10 − 0.60
d. Approximate cost of debt financing:
(100 − 108)
8+ 10
𝑟𝑑 = = 0.0692 𝑜𝑟 6.92%
(108 + 100)
2
After-tax cost of debt = 6.92% × (1 – 0.3) = 4.85%
e. WACC = (0.30 × 0.0485) + (0.40 × 0.32) + (0.3 × 0.1064) = 0.1744 = 17.4% using
retained earnings, or
WACC = (0.30 × 0.0485) + (0.40 × 0.35) + (0.3 × 0.1064) = 0.1864 = 18.6% using
new common

P9-19 Calculation of individual costs and WACC (LG 3, LG 4, LG 5, and LG 6; Challenge)

a. Cost of debt: Net proceeds = Par value ($1,000) – Discount ($30) – Flotation costs ($30)
= $940. The before-tax cost of debt is the interest rate that makes the following equation
hold:
𝑪 𝑪 𝑪 𝑴
Bn = + +…+ +
(𝟏+𝒓𝒅 )𝟏 (𝟏+𝒓𝒅 )𝟐 (𝟏+𝒓𝒅 )𝒏 (𝟏+𝒓𝒅 )𝒏
where:
Bn = Net proceeds from bond sale ($940) M = Par value in dollars ($1,000)
C = Coupon payment each period (8%) rd = yield to maturity (before-tax cost
of debt)
N = periods to maturity (20)
$𝟖𝟎 $𝟖𝟎 $𝟖𝟎 $𝟏,𝟎𝟎𝟎
$940 = + +…+ + = 8.64%
(𝟏+𝒓𝒅 )𝟏 (𝟏+𝒓𝒅 )𝟐 (𝟏+𝒓𝒅 )𝟐𝟎 (𝟏+𝒓𝒅 )𝟐𝟎
 Using the approximation formula we get a slightly different answer:

$1,000  N d After-tax cost of debt rd  (1T)

I
rd  n where:
N d  $1,000 rd = pre-tax cost of debt
2 Nd = Net proceeds from bond sale
n = number of years to maturity
I = Annual interest payments in dollars.
(1000 − 940)
80 + 20
𝑟𝑑 = = 0.0856 𝑜𝑟 8.56%
(940 + 1000)
2
After-tax cost of debt = 8.56% × (1 – 0.21) =6.76%

The after-tax cost of debt is rd × (1 – T ), where T is the tax rate. If that rate is 40%,
after-tax cost of debt is 0.0856 × (1 – 0.4) = 5.14%. With a 21% tax rate, after-tax
cost is 6.76%.
b. Cost of preferred stock: The cost of new preferred stock (rp) is given by (Dp ÷ Np),
where Dp is the expected perpetual annual dividend on preferred stock and Np is net
proceeds from selling new preferred stock. Np = Sales price of new preferred stock –
Flotation costs = $95 – $5 = $90. Preferred dividends are 8% of par value ($95) or
$7.60, so rp = $7.60 ÷ $90 = 8.44%.
c. Cost of new common stock: The cost of new common stock (rn) is given by (D1 ÷ Nn) –
g, where Nn is net sales proceeds. Flotation costs are $5 per share, and new shares must
be underpriced by $7 per share. Net proceeds = Price of common stock (net of
underpricing) – Flotation costs = [($90 – $7) – $5] = $78, so rn = ($7 ÷ $78) + 0.06 =
0.0897 + 0.0600 = 14.97%.

d.
Type of Capital Weights (%) Cost Weighted Cost
With new common stock
Long-term debt 0.30 6.76% 2.028%
Preferred stock 0.20 8.44% 1.689%
Common stock equity 0.50 14.97% 7.487%
1.00 Sum (rWACC)  11.2%*
*problem asks for rWACC to the nearest 0.1%
Note, with a 40% tax rate, the weighted cost of long-term debt is instead 1.542%. So rWACC is
10.7% when equity capital is common stock.

P9-21 Ethics problem (LG 1; Intermediate)

GE’s long string of good earnings reports made the company seem less risky, thereby
reducing returns required by the firm’s bond and stockholders and the firm’s cost of capital.
If investors learn GE is really more risky than it appeared in the past, required returns and
the cost of capital will rise.