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The Cost
of Capital
Lender BalanceRate
First Cut-Throat Bank $ 150,000 7.5%
Second Considerate Bank $ 35,000 8.5%
Third Pawn Mortgage Co. $ 15,000 9.5%
Below what rate would it make sense for Jim to consolidate all
these loans and refinance the whole amount?
Solution
Jim’s weighted average cost of borrowing
= Proportion of each loan * Rate
(150,000/200,000)*.075+(35,000/200,000)
*.085+(15,000/200,000)*.095
(.75*.075) + (.175*.085) (+.075*.095)
= .07825 or 7.825%
The cost of debt (Rd) is the rate that firms have to pay
when they borrow money from banks, finance companies,
and other lenders.
It is essentially measured by calculating the yield to
maturity (YTM) on a firm’s outstanding bonds, as covered in
Chapter 6.
Although best solved for via a financial calculator or
spreadsheet, the YTM can also be figured out as follows:
where Div0 = last paid dividend per share;
Po = current market price per share; and
g = constant growth rate of dividend.
Re = (Div0*(1+g)/Po) + g
($2.27*(1.06)/$45.57)+.0611.28%
Cost of equity with flotation cost:
Re = [$2.27*(1.06)/(45.57*(1-.05)]+.06 11.56%
Solution
1) Calculate the total book value and total market value of the
capital
2) Divide each component’s book value and market value by
their respective totals.
Total Book Value = $375,000,000;
Total Market Value = $426,315,000
Book Value Weights: Market Value Weights:
Debt = $150m/$375m=40%; Debt =
$161.25m/$426.32m=38%
P/ S=$45m/$375m=12%; P/S =
$60m/$426.32=14%
C/S = $180m/$375m=48%; C/S=
$205.07m/$426.32m=48%
(Rounded to nearest whole number)
• The figure illustrates 4 projects, whose IRRs are as follows: Project 1=8%;
Project 2=9%; Project 3=10%; and Project 4=11%. The risk levels also go
from lowmoderatehighvery high
• With a WACC of 9.5%, only Projects 3 and 4, with IRRs of 10% and
11%,respectively, would be accepted.
• However, Projects 1 and 2 could have been profitable lower-risk projects
that are being rejected in favor of higher-risk projects, merely because the
risk levels have not been adequately adjusted for.
2) Select the combination that has the highest NPV, i.e., Combination 1
(projects 1,2,4, and 5) with its total NPV of $1.5m.