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CHAPTER 20 Cost of Capital

The Short Story of WACC
‡ Thus far, we have been given the discount rate with which to evaluate projects; now we consider where it comes from. ‡ Recall that we do not include dividends or interest payments in our DCF analysis because they are included in K. ‡ The WACC considers the cost and weight of individual components in the capital structure.
CHAPTER 20 ± Cost of Capital 20 - 2

The Short Story of WACC
What Costs are Measured?

‡ Costs associated with financing the firm·s invested capital including:
± Debt Costs:
‡ Bank loans ‡ Long-term debt ± bonds/debentures Long-

± Equity Costs:
‡ Preferred equity costs ‡ Common equity costs

CHAPTER 20 ± Cost of Capital

20 - 3

The Short Story of WACC
Why the Marginal Cost?

‡ What capital cost the firm 5 months, 5 years or 5 decades ago is irrelevant. ‡ What is relevant is what the next dollar of capital will cost in today·s economic environment for this particular firm.

CHAPTER 20 ± Cost of Capital

20 - 4

The Short Story of WACC
Steps in Solving for the WACC

1. Identify the relevant sources of capital (debt and equity). 2. Estimate the market values for the sources of capital and determine the market value weights. 3. Estimate the marginal, after-tax, and afterafterafterfloatation cost for each source of capital. 4. Calculate the weighted average.

CHAPTER 20 ± Cost of Capital

20 - 5

preferred and debt: V = S + P + D ‡ Throughout the course. preferred share financing and debt is: [ 20-9] WACC ! K e D P S  K p  K d ( 1-T) V V V ‡ In this case the value of the firm equals the sum of the value of stock. you will see me use the notation Wd for the weight of debt instead of (D/V) ² likewise with We and Wp (weight of common and preferred equity respectively) CHAPTER 20 ± Cost of Capital 20 .6 .The Cost of Capital Determining the Weighted Average Cost of Capital (WACC) ‡ The equation for WACC including common equity.

CHAPTER 20 ± Cost of Capital 20 .5% 11.05934 .The Short Story of WACC The Spreadsheet Approach (1) (2) (3) (4) = (2)*(3) Type of Capital o -Ter De t referred Stoc Co o Stoc Specific Marginal Cost Weighted after tax and Market Specific floatation Value Marginal costs Weights Cost 5.4% 12.9% 43.01254 0.0% WACC = 0. % WACC is the su of the wei hted specific ar i al costs of each source of capital.02365 0.0% 46.0% 11.7 .

CHAPTER 20 ± Cost of Capital 20 .Market Values! ‡ Always remember when calculating the weights of various capital sources to use the TOTAL MARKET VALUE of these instruments. not the book values listed on the balance sheet.8 . ± Recall that market capitalization is the total value of COMMON EQUITY! ‡ This can be tricky for debt if required yields have changed substantially from when the debt was issued ² we have to look up (or recalculate) the market price of bonds rather than their par value.

9 . knowing the term to maturity. the coupon rate and the bondholder·s required return we can determine the market value of bonds with equation 20 ² 12 ‡ Then simply multiply the price by the number of bonds outstanding. [ 20-12] 1 » « ¬1 (1 k )n ¼ 1 b ¼  Fv B ! I v¬ kb (1 kb )n ¼ ¬ ¼ ¬ ½ ­ CHAPTER 20 ± Cost of Capital 20 .Estimating Market Values Market Value of Bonds ‡ As per Chapter 6.

10 .Costs of Existing Capital ‡ Cost of Debt = Kd = Y (1-T) (1‡ Cost of Preferred Shares = Kp = D/P0 ‡ Cost of Equity = Ke = (D1/P0)+ g CHAPTER 20 ± Cost of Capital 20 .

using it only for large. mature µblue-chip¶ µbluecompanies that already pay a significant dividend ‡ The Gordon model SHOULD NOT be used on smaller. more rapidly growing firms where high current growth rates are experienced.Cost of Equity Constant Growth Model Caution ‡ The constant growth model can only be used in cases where it is reasonable to assume that the growth rate can be sustained in the very long term. but cannot be sustained in the long term. ± This usually means. CHAPTER 20 ± Cost of Capital 20 .11 .

12 . today as the yield on -day T-bills T± The market risk premium (MRP) is taken from current market estimates of the overall return in the market. less RF (ERM ±RF) ± Using this model requires us to think about the inputs however as they can have a significant impact on project evaluation CHAPTER 20 ± Cost of Capital 20 .Alternate Model for the Cost of Equity Using the CAPM to estimate Ke ‡ CAPM can be used to estimate the required return by common shareholders in situations where DCF methods will perform poorly ‡ CAPM estimate is a ¶market determined· estimate: ± The RF (risk-free) rate is the benchmark return and is measured (riskdirectly.

RiskRisk-Based Models & the Cost of Equity Using the CAPM to estimate the cost of common equity ‡ As a single-factor model.13 . we estimate the common singleshareholder·s required return based on an estimate of the systematic risk of the firm (measured by the firm·s beta coefficient) [ 20-26] K e ! RF  MRP v F e ‡ Where: Ke = investor¶s required rate of return e = the stock¶s beta coefficient Rf = the risk-free rate of return riskMRP = the market risk premium (ERM .Rf ) CHAPTER 20 ± Cost of Capital 20 .

± We really need a µforward¶ looking of MRP or a µforward¶ looking estimate of the ERM ‡ One approach is to use an estimate of the current. CHAPTER 20 ± Cost of Capital 20 . expected MRP by examining a long-run average that prevailed in the longpast. ‡ Table 20 -12 illustrates the % returns on S&P/TSX Composite annually for the first five years of this century.14 .RiskRisk-Based Models & the Cost of Equity Estimating the Market Risk Premium [ 20-26] K e ! RF  MRP v F e ‡ Rf is ¶observable· (yield on 91-day T-bills) 91T‡ Getting an estimate of the market risk premium is one of the more difficult challenges in using this model.

15 .RiskRisk-Based Models & the Cost of Equity Using the CAPM to Estimate the Cost of Common Equity Tabl 20-12 R t so t &P/T X Composit I R t 7 7 8 7 7 7 8 s It would be unlikely to expect better to use negative returns on the stock average market If they realized did. no one would returns over hold shares! an entire Who would have business/mar guessed before ket cycle hand. there would be two consecutive years of aggregate market losses? Such is the reality of investing since none of us are clairvoyant Investors are CHAPTER 20 ± Cost of Capital 20 .

RiskRisk-Based Models & the Cost of Equity Using the CAPM to Estimate the Cost of Common Equity Long.un a e age ates of etu n a e mo e eliable Ta le 20-1 Ave age nvest ent Retu ns and tanda d Deviations (1 to 200 ) Annual Annual tanda d A ith etic Geo et ic Deviation of Annual ean ( ) Ave age ( ) Retu ns ( ) o e nment of Canada easu y Bills o e nment of Canada Bonds Canadian to ks to ks U ou e: ata f om Canadian Institute of A tua ies 5 20 6 62 11 9 13 15 5 11 6 24 10 60 11 6 4 32 9 32 16 22 1 54 A e age isk p emium ofis that the Canadian MRP o e the long-te he onsensus Canadian sto ks oyield (an obse able yield) is between 4 0 and 5 5 bond e bonds was 5 1 CHAPTER 20 ± Cost of Capital m 20 .16 .

an estimate for the company beta is required.RiskRisk-Based Models & the Cost of Equity Estimating Betas ‡ After obtaining estimates of the two important market rates (Rf and MRP). ‡ Figure 20 -3 illustrates that estimated betas for major sub-indexes of the S&P/TSX have varied subwidely over time: CHAPTER 20 ± Cost of Capital 20 .17 .

18 .RiskRisk-Based Models & the Cost of Equity Estimated Betas for Sub Indexes of the S&P/TSX Composite Index 20 .3 F URE CHAPTER 20 ± Cost of Capital 20 .

19 .RiskRisk-Based Models & the Cost of Equity Estimated Betas for Sub Indexes of the S&P/TSX Composite Index ‡ You should note: ± IT sub index shows rapidly increasing betas ± Other sub index betas show constant or decreasing trends ‡ Reasons: (by definition they are ± The weighted average of all betas = the market) ± If one sub index is changing«that change alone affects all others in the opposite direction ‡ What Happened in the 1995 ² 2005 decade? s resulted in rapid growth in ± The internet bubble of the late the IT sector till it burst in the early s CHAPTER 20 ± Cost of Capital 20 .

RiskRisk-Based Models & the Cost of Equity Estimating Betas IT Bubble Ta 20-15 E r TSX Sub Index Beta Est at rials ates Co s tap H alt i T T l o tiliti s strials Co s is our e Data from Finan ia - ¤£ ¢ ¡   o Corpora e Ana er Da aba e CHAPTER 20 ± Cost of Capital 20 .20 .

plus the individual company beta estimate. ± Using current MRP and Rf Develop estimates of Ke using the range of Company betas prior to the bubble or crash CHAPTER 20 ± Cost of Capital 20 .RiskRisk-Based Models & the Cost of Equity Adjusting Beta Estimates and Establishing a Range ‡ When betas are measured over the period of a sector bubble or crash. it is necessary to adjust the beta estimates of firms in other sectors.21 . ‡ Take the industry grouping as a major input.

Costs of Existing Capital ‡ Cost of Debt = Kd = Y (1-T) (1‡ Cost of Preferred Shares = Kp = D/P0 ‡ Cost of Equity = Ke = (D1/P0)+ g = R f + ( R m ² R f) CHAPTER 20 ± Cost of Capital 20 .22 .

23 . ‡ THIS IS OK! ± Recall that the cost of equity capital is an estimate which tries to approximate what shareholders require as a return compensating them for the risks they face ‡ When you have enough information to calculate both.Cost of Equity Capital ‡ It is extremely rare that the Gordon model and the CAPM will give you the same cost of equity. CHAPTER 20 ± Cost of Capital 20 . do so and then use their average as the cost of equity.

and ± The component cost of capital > investor¶s required return Table 20 4 ± illustrates average issuing costs for different forms of capital. CHAPTER 20 ± Cost of Capital 20 .Estimating the Component Costs Floatation Costs ‡ Issuing or floatation costs are incurred by a firm when it raises new capital through the sale of securities in the primary market.24 . ‡ These costs include: ± Underwriting discounts paid to the investment dealer ± Direct costs associated with the issue including legal and accounting costs ‡ The result: ± Net proceeds on the sale of each security is less than what the investor invests.

. and up Commer ial paper Medi m-term notes ong-term de t E uit (large) E uit (small) E uit (pri ate) . .Estimating the Component Costs Floatation Costs and the Marginal Cost of Capital (MCC) Floatation osts for t s uriti s is low st aus t is nor all pri at l wit larg pla institutional inv stors not r quiring un rwriting osts an aus t is it r issu igh qualit issu rs or sits at th top of th priorit of lai s list in th as of fault Ta l 20- A ra ssuing Costs . What issue osts mean is that there is a finan ing wedge etween what the in estor pa s and what the firm re ei es.. the differen e eing the mone that is lost to these osts. . Issue osts are responsi le for the omponent ost of apital eing greater than the in estor¶s required return.25 . CHAPTER 20 ± Cost of Capital 20 . . .

CHAPTER 20 ± Cost of Capital 20 . ± Kx new = Kx / ( -fl%) ‡ The Net Proceeds method scales the cost of capital by replacing the ´priceµ in those same equations with the actual amount of funds received from the public.Floatation Cost Calculation ‡ There are two approaches to factoring in floatation costs: ± % Floatation Method ± Net Proceeds Method ‡ The % Floatation method uses the initial cost of capital estimates we saw earlier.26 . but divides them by (1-floatation %) to (1account for the financing wedge.

27 . use the net proceeds method (its not in this course so % float method is fine to use in all cases) CHAPTER 20 ± Cost of Capital 20 . the % float method can be used equivalently to the net proceeds method ± % Float estimates are slightly lower than Net Proceeds estimates for Ke ± If precision is ESSENTIAL. and real world market frictions introduce much larger errors in estimation.Floatation Cost Calculation ‡ These two forms give identical results except in the case of common equity where there is a minor distortion introduced by using % Float. ‡ Since the cost of capital calculation only gives us an estimate.

T) 1 .19% 1 .0.28 .0 .4) 6% ! ! 6.03 0. you can estimate the cost of debt in the following manner: Assume: Kd = % (debt investor¶s required return) T = % (corporate tax rate) fd = % (floatation cost percentage) The after tax cost of debt is lower than the investor¶s required return because of the tax shield on interest expense ‡ KDnew ! Investor's Required Return v (1 .%fld ! 10% v (1.The Component Cost of Debt ‡ If you know the debt investor·s required rate of return Kd ..97 CHAPTER 20 ± Cost of Capital 20 . the corporate tax rate and the floatation cost percentage for debt.

29 . afterafterCHAPTER 20 ± Cost of Capital 20 .Estimating the Component Costs Debt ‡ Alternatively you can adjust the bond valuation formula for the taxtax-deductibility of interest expense and the net proceeds the firm would receive on the sale of one bond (after floatation costs) and solve for the rate (Ki ) that causes the formula to (K become and equality: Coupon interest times minus corporate tax rate = after tax cost of interest [ 20-13] 1 « ¬1  ( 1  )n Dnew N ! I v (1  ) v ¬ Dnew ¬ ¬ ­ » ¼ ¼ ¼ ¼ ½ v 1 (1 Dnew )n Net proceeds on the sale of the bond = Selling price ± floatation cost per bond ‡ Ki = the after-tax and after-floatation cost of debt.

and the floatation cost percentage for preferred share financing. therefore there are no taxation effects on the preferred share component cost of capital CHAPTER 20 ± Cost of Capital 20 .30 .95 Floatation costs cause the component cost to be greater than the investor¶s required return ‡ NOTE: Preferred dividends are paid out of aftertax earnings.Estimating the Component Costs Preferred Shares ‡ If you know the preferred share investor·s required rate of return Kp ..%fl p ! 14% 14% ! ! 14.05 0. you can estimate the cost of preferred shares in the following manner: Assume: Kp = % (preferred investor¶s required return) F = % (floatation cost percentage) KPnew ! Investor' s Required Return 1 .74% 1 .

[ 20-14] K new ! Dp N CHAPTER 20 ± Cost of Capital 20 . the component cost of preferred shares can be found using equation 20 -14. where NP is the selling price per preferred share less the floatation costs per share.31 .Estimating the Component Costs Preferred Shares ‡ Alternatively.

Constant Growth Model The Cost of New Equity ‡ The model can be modified to solve for the cost of new equity by using NP (net proceeds the firm receives for each new share sold after floatation costs) D1 g N [ 20-17] K Enew ! CHAPTER 20 ± Cost of Capital 20 .32 .

33 .RiskRisk-Based Models and the Cost of Common Equity Using CAPM to Estimate Kne ‡ We can scale our estimate of the equity holder·s required return when accessing new equity and incurring floatation costs. [ 20-27] K Ene KE ! (1  % fle ) CHAPTER 20 ± Cost of Capital 20 .

34 . ± example after the break CHAPTER 20 ± Cost of Capital 20 .A note of new vs existing capital ‡ UNDER NO CIRCUMSTANCES can a firm use existing debt or existing preferred shares to finance a project! ± There is no such thing as KD or KP except when using it to calculate KDnew and KPnew ± Money raised from these sources but not spent end up as common equity ‡ Only in the case of existing common equity can we use KE otherwise we use KEnew.

and then have to access marginally higher cost sources.35 The following figure illustrates the MCC concept. ± Therefore MCC increases with the amount of capital to be raised CHAPTER 20 ± Cost of Capital 20 . it will exhaust the supply of lower cost sources.WACC versus MCC Floatation Costs and the Marginal Cost of Capital (MCC) ‡ The Marginal Cost of Capital (MCC) is the weighted average cost of the next dollar of financing to be raised. . ‡ At low levels of financing the WACC = MCC ‡ As a firm raises more and more capital in a given year.

5 million is financed 0% by new equity.000 $ . ! K Enew 15 S D  K Dnew (1  t ) V V 60 40 ! 14%  8%(1  .5 million is financed 0% by internal equity (R/E). (40% × after-tax cost = 2.500.000 CHAPTER 20 ± Cost of Capital ¥ ollars of Capital to be aised 20 .6)  5.64% Each dollar of capital invested beyond $5.6%(.4) ! 8. It ! 12%  8%(1  .3) 100 100 occurs at $5.24%) 0 $ .44% Each dollar of capital invested up to $5.000 $ 0.36 .24% Each dollar of capital invested is financed 40% by debt.000 $ .4%) 5 2.000.6%(.000. ( 0% × cost of retained earnings = .24% ! 10.6)  5.2%  2.4) equity capital will mean accessing external ! 7.3) 100 100 ! 14%(.24% ! 9.000. At this point the firm has exhausted its internal equity and to raise more ! 12%(.000. ( 0% × cost of new equity = .000.The Marginal Cost of Capital MCC (%) MCC1 ! K e S D  K Dnew (1  t ) MCC 2 V V 60 40 There is only one break in the CC curve.44% equity using the services of an underwriter.2%) MCC2= 10.64% 10 MCC1=WACC= 9.000 $ .000.4%  2.

Investment Opportunity Schedule A Detailed Example « ‡ An investment opportunity schedule is a prioritized list of capital projects.000 $180.000 $2.000 7 $14.37 .540 5 $222.000 $2.159 8.06% $940.000 CHAPTER 20 ± Cost of Capital 20 .945 13.45% $318.300.154.000 6 $343.000 7 -$88.671 11. Initial Cost $1.500.000 $3.750.50% $421.000 $985.07% $40. listed by IRR from highest to lowest.517 18.19% $529. ‡ Consider the 6 projects below: Project A can be Capital Project A B C D E F Annual ATCF Useful Benefits Life NPV IRR $290.500 8 $94.737 12.933 10.000 6 $3.20% eliminated at this point because it has a negative NPV.

50 13.20% 10.000 $9.000 $1 0.38 .000 $7.369. 35.000 $4.000 $2. 69.06% 8. 50. and then to calculate the cumulative capital cost of the projects.154.07% 12.000 $4.45% 11.000 $2.000 RR 1 .000 $10.300.19% CHAPTER 20 ± Cost of Capital 20 .000 $3.069.500.Investment Opportunity Schedule A Detailed Example « The first step in developing an IOS is to order the projects from highest IRR to lowest.915. Capital P oject E C D F B A C lati e Cost itial Cost of t e P ojects $9 5.000 $9 5.000 $1.

that is.39 . ‡ Then we overlay the MCC graph we just saw to determine which projects provide sufficient returns CHAPTER 20 ± Cost of Capital 20 . ‡ Now we can prepare a graphical representation of the IOS by plotting the projects¶ IRR against the cumulative dollars of capital to be raised.Investment Opportunity Schedule A Detailed Example Continued « ‡ The remaining projects certainly meet the first investment screen . they offer rates of return in excess of the firm¶s WACC (they have a positive NPV).

000.000 $10.5% The height of each cylinder is equal to the project¶s IRR. D C I = 13.06% 5 0 $2.000.000 Dollars of Capital to be aised CHAPTER 20 ± Cost of Capital 20 .000 $ .000.2% I 10 B = 10.000.45% The upper surface of the columns is the IOS F I = 11.000.Investment Opportunity Schedule (IOS) A Detailed Example Continued « I (%) 15 E = I 18.000 $4. the width is equal to the initial investment for the project.40 .000 $ .07% I = 12.

000 $4.000.2% I B = 10.45% IOS 10 F I = 11.000.000.000 $ .000 $ .000 $10.000.5% D C I = 13.41 .06% 5 0 $2.000.000 Dollars of Capital to be aised CHAPTER 20 ± Cost of Capital 20 .07% I = 12.Investment Opportunity Schedule (IOS) A Detailed Example Continued « I (%) 15 E = I 18.

45% 10 MCC2= 10. I (%) 15 E = I 18.000.06% 0 $2.increase the incurring floatation costs.42 .07% I = 12.000.000.000. to finance project F through external will not offering of equity.000 $10.000 $ . of the value firm.5% D C I = 13.000 $4.000 $ .MCC Superimposed on the IOS A Detailed Example Continued « The break in the MCC is < MCC2 IRRB caused by the exhaustionso this project of low cost retained earnings and the need It is rejected.2% I B = 10.64% MCC1=WACC= 9.000.000 Dollars of Capital to be aised CHAPTER 20 ± Cost of Capital 20 .44% I 5 F = 11.

± More on this next class CHAPTER 20 ± Cost of Capital 20 . ‡ The solution to this is to develop risk-adjusted discount rates riskthat reflect the unique risk characteristics of each division.Divisional Costs of Capital ‡ An overall cost of capital developed for a highly diversified conglomerate may not be appropriate for decisions made within specific divisions of the company.43 . ‡ High-risk divisions (with high return possibilities) would have a Highdisproportionate share of their investment proposals accepted if they use an overall WACC. ‡ Developing these estimates can sometimes be accomplished by looking at other firms in that industry that are not highly diversified in their operations« this is called the pure play approach.

Appendix 1 Steep Hill Mines 1 An Exercise in Cost of Capital .

Steep Hill Mines # 1 The Question Steep Hill Mines Ltd. Dividends have been growing at a 4% compound rate for the past six years and the expectation is that this growth can continue into the foreseeable future. It will cost Steep Hill $400.000 for the next eight years. The shares currently trade at a price of $ 0. Project A is expected to produce annual cash flows after tax of $100. Security analysts that follow the stock have estimated it's beta coefficient to be 0. It is considered to be of similar risk to the risk of the firm itself. 5% bonds have ten years left until they mature. shares are publicly traded on the Toronto Stock Exchange. Steep Hill Mines Ltd.00 per share. longThe bonds are currently trading at a discount from their par value of 96.000 this year to get this project up and running.50 per share. Steep Hill paid a dividend on its common stock last year that totaled $1. CHAPTER 20 ± Cost of Capital 20 .45 . Steep Hill also has it's long-term bonds trading on public markets. has an important capital project to consider.54%. These 5.9.

± The firm faces a corporate tax rate of 40%. The firm's most recent financial statements are found below: CHAPTER 20 ± Cost of Capital 20 .25%. ± If the firm goes ahead with the capital project. Steep Hill's manager of finance has collected current data from the firm's underwriters. but floatation costs would amount of 4% of the value of the issue.46 . but the floatation cost percentage would be 6%. 91± The expected return on the TSE 00 composite index is forecast to be 10% in the next year ± New equity capital could be raised by the firm at the current market price.Steep Hill Mines # 1 The Question « Cathy Jones. ± Government of Canada 91-day Treasury bills are currently yielding 4. ± New bonds could be sold into the market. ± The company will seek to sustain the current capital structure based on existing market value weights. it will have to seek external financing since there is no internal cash flow available for reinvestment.

270 TOTAL CLAIMS Assets: Cash 100 Accounts Receivable Inventories Total Current Assets Gross Fixed Assets Accumulated Depreciation Net Fixed Assets TOTAL ASSETS 312 ____ 342 1. Using the target capital structure weights.000 1.500 Common stock (100.000 928 3.270 Required: Find the WACC using book value weights.000 outstanding) Retained earnings 2. 20XX In $ '000s Liabilities: Accruals 30 220 Accounts Payable 450 770 Total Current Liabilities 4.000 5.47 .500 3.75% bonds 1. market value weights and target capital structure weights. is the proposed project viable? CHAPTER 20 ± Cost of Capital 20 .Steep Hill Mines # 1 The Question « Steep Hill Mines Ltd. Balance Sheet As at December 31.

2% $30 $30 P0 CAPM Approach: K S ! RF  Bs [ ERM  RF ] ! 4.04 !  .04 ! 0.04 ! 9.25%  5.052  .Steep Hill Mines # 1 The Solution ± The Equity Investor¶s Required Return Investor's Required Return on Equity Capital: DDM Approach: KS ! $1.25%] K S ! 4.425% CHAPTER 20 ± Cost of Capital 20 .9[10%  4.25%  0.50(1.56 D0 (1  g ) g!  .04) $1.175% ! 9.48 .

3% ! ! ! 9 .425)/2 = 9 3 This is the returns our current shareholders are demanding on our stock. etc. If we raise external capital.3% 9.. Cost of Ne Equity ! Investors equired eturn 1.Steep Hill Mines # 1 The Solution ± The Cost of Equity Investor's Required Return on Equity Capital The average of our two estimates for the cost of retained earnings is: (9. we will incur floatation costs (underwriter's fees.4 CHAPTER 20 ± Cost of Capital 20 . legal costs.49 .) This represents 4%.96 1 .2 + 9.f 9.7 % .

75 ¬ kb ( 1  k b ) 20 ¬ ¼ ¼ ¬ ½ ­ [ 20-12] 1 « 1 ¬ ( 1  k b )n B ! Iv¬ kb ¬ ¬ ­ k b ! 3 . 22 % CHAPTER 20 ± Cost of Capital 20 .Steep Hill Mines # 1 The Solution Investor's Required Return on Debt » ¼ 1 ¼Fv ( 1  k b )n ¼ ¼ ½ 1 » « 1 20 ¼ ¬ 1 ( 1  kb ) ¼Fv $965.11 % v 2 ! 6 .11 % se iannual ly k b ! 3 .40 ! $28.50 .

22%(1  . the after-tax a after- 6.22%(1  T ) 6.4) Kd ! ! ! 3.97% 1 f 1  .51 .Steep Hill Mines # 1 The Solution ± The Cost of Debt i ce i terest o e t is tax e e after floatatio cost of e t is: cti le to the firm.06 here: T f 40 6 CHAPTER 20 ± Cost of Capital 20 .

2435 75 65 24 35 CHAPTER 20 ± Cost of Capital 20 .000 3.400 3.400 $3.000 o s o tsta arket al e of Eq it 100.400 ei ht of LT e t $965.965.965.000.000 times $30 00 TOTAL ARKET ALUE OF THE F R arket al e arket al e i times $965 40 $965.52 .400 ei ht of Eq it 1 .Steep Hill Mines # 1 The Solution ± Determining Market Value Weights Market Value Weights: arket al es are alwa s fo m ltipl i the m er of o tsta i sec rities times their price per it arket al e of LT e t 1.

53 .Steep Hill Mines # 1 The Solution ± Market Value WACC The Cost of Capital Usi arket al e ei hts: Sour e o Capital T e t re erre Co on Market Value W ei ht Spe i i Mar inal Cost W ei hte Cost W ACC 30 CHAPTER 20 ± Cost of Capital 20 .

let's use that in the WACC. we can just use the firm's WACC. CHAPTER 20 ± Cost of Capital 20 . and calculate the project¶s NPV. we do not have to calculate a riskriskadjust discount rate«instead. Since the market value capital structure weights will be used by the firm in the long run.54 .Steep Hill Mines # 1 The Solution ia ilit of the Capital Pro ect Since the project has similar risk characteristics to the firm as a whole.

. and substituting in the annual cash flow benefits of $100.000(5.3% )  $400.681788)  $400.000( VIFA n !8. initial cost.083 ! $100.000 ! $568.k ! WACC )  $400.k !8. and WACC of .Steep Hill Mines # 1 The Solution ± Project NPV CF1 CF2 CF3    .083)8 ! $100.000  $400. 20 .000 aftertax.3% we find the project offers a positive NPV.55 .  CF0 2 3 1 (1  k ) (1  k ) (1  k ) n [ 13-1] N V! § CF ! i !1 t t (1  k )  CF0 ! $100.000 ! $100. useful life of years.178 CHAPTER 20 ± Cost of Capital Using Equation 13 -1 for NPV.000( VIFA n !8..000 .178  $400.000 1N V ! $168.000 1 (1.