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ra = 0.04(7%)+0.60(16%)
ra = 2.8% + 9.6%
ra = 12.4%
c. Reject project 263. Accept project 264.
d. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as
a criterion provides better decisions because it takes into consideration the long-run
interrelationship of financing decisions.
Chapter 10
N d = $980
b.
Cash flows:
T
0
115
15
CF
$ 980
120
1,000
c. Cost to maturity:
I M
n
+
B0 =
t
n
t =1 (1 + r ) (1 + r )
15 $120 $1,000
+
$980 =
t
15
t =1 (1 + r ) (1 + r )
$1,000 N d
n
rd =
N d + $1,000
2
($1,000 $980)
$120 +
15
rd =
($980 + $1,000)
2
rd = $12.33 $990,00
rd =
$1,000 N d
n
N d + $1,000
2
I+
rd = 12.26%
rd =
($1,000 $980)
15
($980 + $1,000)
2
$120 +
rd =
$1,000 N d
n
N d + $1,000
2
I+
ri = rd (1 T)
Bond A
rd =
$1,000 $955
$92.25
20
=
= 9.44%
$955 + $1,000
$977.50
2
$90 +
Chapter 10
Bond B
rd =
$1,000 $970
$101.88
16
=
= 10.34%
$970 + $1,000
$985
2
$100 +
$1,000 $955
$123
15
=
= 12.58%
$955 + $1,000
$977.50
2
$120 +
$1,000 $985
$90.60
25
=
= 9.13%
$985 + $1,000
$992.50
2
$90 +
$1,000 $920
$113.64
22
=
= 11.84%
$920 + $1,000
$960
2
$110 +
a.
rp =
$12.00
= 12.63%
$95.00
b.
rp =
$10.00
= 11.11%
$90.00
Calculation
A
B
C
D
E
rs = RF + [b (rm RF)]
rs = 6% + 1.2 (11% 6%)
rs = 6% + 6%
rs = 12%
a. Risk premium = 6%
b. Rate of return = 12%
c. After-tax cost of common equity using the CAPM = 12%
P10-9. LG 3: Cost of common stock equity: kn =
D1 + g
Nn
Intermediate
D
a. g = 2009 = FVIFk %,4
D2005
$3.10
= 1.462
$2.12
From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).
Calculator solution: 9.97%
g=
rr =
D2010
+g
P0
rr =
$3.40
+ 0.10 = 15.91%
$57.50
d. rr =
rr =
D2010
+g
Nn
$3.40
+ 0.10 = 16.54%
$52.00
Chapter 10
D1
+g
P0
rn =
D1
+g
Nn
Firm
Calculation
Book Value
Weight
Cost
Weighted Cost
L-T debt
Preferred stock
Common stock
$ 700,000
50,000
650,000
$1,400,000
0.500
0.036
0.464
1.000
5.3%
12.0%
16.0%
2.650%
0.432%
7.424%
10.506%
b. The WACC is the rate of return that the firm must receive on long-term projects to maintain
the value of the firm. The cost of capital can be compared to the return for a project to determine
whether the project is acceptable.
P10-12. LG 4: WACCbook weights and market weights
Intermediate
a. Book value weights:
Type of Capital
Book Value
Weight
Cost
Weighted Cost
L-T debt
Preferred stock
Common stock
$4,000,000
40,000
1,060,000
$5,100,000
0.784
0.008
0.208
6.00%
13.00%
17.00%
4.704%
0.104%
3.536%
8.344%
Market Value
Weight
Cost
Weighted Cost
L-T debt
Preferred stock
Common stock
$3,840,000
60,000
3,000,000
$6,900,000
0.557
0.009
0.435
6.00%
13.00%
17.00%
3.342%
0.117%
7.395%
10.854%
c. The difference lies in the two different value bases. The market value approach yields the
better value since the costs of the components of the capital structure are calculated using the
prevailing market prices. Since the common stock is selling at a higher value than its book
value, the cost of capital is much higher when using the market value weights. Notice that the
book value weights give the firm a much greater leverage position than when the market value
weights are used.
P10-13. LG 4: WACC and target weights
Intermediate
a. Historical market weights:
Type of Capital
Weight
Cost
Weighted Cost
L-T debt
Preferred stock
Common stock
0.25
0.10
0.65
7.20%
13.50%
16.00%
Type of Capital
Weight
Cost
Weighted Cost
L-T debt
Preferred stock
Common stock
0.30
0.15
0.55
7.20%
13.50%
16.00%
2.160%
2.025%
8.800%
12.985%
1.80%
1.35%
10.40%
13.55%
c. Using the historical weights the firm has a higher cost of capital due to the weighting of the
more expensive common stock component (0.65) versus the target weight of (0.55). This
over-weighting in common stock leads to a smaller proportion of financing coming from the
significantly less expense L-T debt and the lower costing preferred stock.
Chapter 10
I+
rd =
($1,000 $950)
$100 + $5
10
=
= 10.77%
($950 + $1,000)
$975
2
$100 +
rd =
ri = 10.77 (l 0.40)
ri = 6.46%
Cost of preferred stock: rp =
Dp
Np
$8
= 12.70%
$63
rp =
D2009
= FVIFk %,4
D2005
g=
$3.75
= 1.316
$2.85
D1
+g
P0
From FVIF table, the factor closest to 1.316 occurs at 7% (i.e., 1.311 for 4 years).
Calculator solution: 7.10%
rr =
$4.00
+ 0.07 = 15.00%
$50.00
rn =
b.
$4.00
+ 0.07 = 16.52%
$42.00
Breaking point =
BPcommon equity =
AFj
Wj
[$7,000,000 (1 0.6* )]
= $5,600,000
0.50
Between $0 and $5,600,000, the cost of common stock equity is 15% because all common stock
equity comes from retained earnings. Above $5,600,000, the cost of common stock equity is
16.52%. It is higher due to the flotation costs associated with a new issue of common stock.
10
The firm expects to pay 60% of all earnings available to common shareholders as dividends.
c. WACC$0 to $5,600,000:
L-T debt
0.40 6.46%
Preferred stock 0.10 12.70%
Common stock 0.50 15.00%
WACC
=
=
=
=
2.58%
1.27%
7.50%
11.35%
d. WACCabove $5,600,000:
L-T debt
0.40 6.46% =
Preferred stock 0.10 12.70% =
Common stock 0.50 16.52% =
WACC =
2.58%
1.27%
8.26%
12.11%
Loan 1
Loan 2
Loan 3
Total
Rate
[1]
6.00%
9.00%
5.00%
$20,000
$12,000
$32,000
$64,000
Weight
[2] 64,000 = [3]
31.25%
18.75%
50.00%
WACC
[1] [3]
1.88%
1.69%
2.50%
6.06%
John Dough should not consolidate his college loans because their weighted cost is less than
the 7.2% offered by his bank.
P10-16. LG 2, 3, 4, 5: Calculation of specific costs, WACC, and WMCC
Challenge
a. Debt: (approximate)
rd =
rd =
($1,000 N d )
n
( N d + $1,000)
2
I+
($1,000 $940)
$80 + $3
20
=
= 8.56%
($940 + $1,000)
$970
2
$80 +
ri = rd (1 t)
ri = 8.56% (1 0.40)
ri = 5.14%
Preferred stock:
rp =
rp =
Dp
Np
$7.60
= 8.44%
$90
Chapter 10
11
Common stock:
rn =
rp =
Dj
Nn
+g
$7.00
= 0.06 = 0.1497 = 14.97%
$78
Retained earnings:
rr =
D1
+g
P0
rp =
$7.00
+ 0.06 = 0.1378 = 13.78%
$90
b. Breaking point =
1.
AFj
Wi
BPcommon equity =
[$100,000 ] = $200,000
0.50
Target
Cost of
Capital
Capital Source
Structure%
Type of Capital
2.
3.
Weighted
Cost
0.30
0.20
0.50
5.1%
8.4%
13.8%
1.53%
1.68%
6.90%
WACC = 10.11%
0.30
0.20
0.50
5.1%
8.4%
15.0%
1.53%
1.68%
7.50%
WACC = 10.71%
Cost%
Long-term debt
6
8
Preferred stock
Common stock
equity
17
20
24
Range of New
Financing
Breaking
Point
Range of Total
New Financing
$0$320,000
$320,001
and above
$0 and above
$0$200,000
$200,001
$0$800,000
Greater than
$800,000
Greater than $0
$0$500,000
Greater than
12
and above
$500,000
Chapter 10
Target
Proportion
Cost%
Weighted Cost
(2) (3)
(1)
(2)
(3)
(4)
$0 $500,000
Debt
Preferred
Common
0.40
0.20
0.40
$500,000 $800,000
Debt
Preferred
Common
0.40
0.20
0.40
Greater than
$800,000
Debt
Preferred
Common
0.40
0.20
0.40
Range of Total
New Financing
6
2.40%
17
3.40%
20
8.00%
WACC = 13.80%
6%
2.40%
17%
3.40%
24%
9.60%
WACC = 15.40%
8%
3.20%
17%
3.40%
24
9.60%
WACC = 16.20%
E
C
G
A
H
I
B
D
F
IRR
Initial
Investment
Cumulative
Investment
23%
22
21
19
17
16
15
14
13
$200,000
100,000
300,000
200,000
100,000
400,000
300,000
600,000
100,000
$ 200,000
300,000
600,000
800,000
900,000
1,300,000
1,600,000
2,200,000
2,300,000
13
14
e. The firm should accept Investments E, C, G, A, and H, since for each of these, the IRR on the
marginal investment exceeds the WMCC. The next project (i.e., I) cannot be accepted since its
return of 16% is below the weighted marginal cost of the available funds of 16.2%.
P10-18. Ethics problem
Intermediate
The company would likely try to deny the claim on the basis that no damages have been sustained
or proven by the claimant. The claimant would argue that the company might not be around to
pay damages when the symptoms emerge and that the damage has already been done even if the
symptoms are not present.
Case
Chapter 10
ri = rd (1 t)
ri = 9.46 (1 0.4)
ri = 5.68%
Above $450,000:
ri = rd (1 t)
ri = 13.0 (1 0.4)
ri = 7.8%
Preferred stock:
rp =
rp =
Dp
Np
$9.80
= 0.1508 = 15.08%
$65
Di
+g
P0
rr =
$0.96
+ 0.11 = 19%
$12
rr =
Di
+g
Nn
rr =
$0.96
+ 0.11 = 21.67%
$9
Above $1,500,000:
2.
Breaking points
Breaking point =
AFj
Wi
$450,000
= $1,500,000
0.30
$1,500,000
BPcommon equity =
= $2,500,000
0.60
BPLong-term debt =
Type of Capital
1.
From $0 to $1,500,000:
Long-term debt
Preferred stock
Common stock equity
Target Capital
Structure %
Cost of Capital
Source
0.30
0.10
0.60
5.7%
15.1%
19.0%
Weighted
Cost
1.71%
1.51%
11.40%
15
16
2.
3.
1.00
WACC = 14.62%
7.8%
2.34%
15.1%
1.51%
19.0%
11.40%
WACC = 15.25%
Above $2,500,000:
Long-term debt
Preferred stock
Common stock equity
0.30
0.10
0.60
1.00
7.8%
2.34%
15.1%
1.51%
21.7%
13.02%
WACC = 16.87%
Chapter 10
17
4.
5. Projects C, D, B, F, and E should be accepted, because each has an IRR greater than the WACC.
These projects will require $2,400,000 in new financing.
Spreadsheet Exercise
The answer to Chapter 10s measurement of the cost of capital at Nova Corporation spreadsheet problem
is located in the Instructors Resource Center at www.prenhall.com/irc.
A series of chapter-relevant assignments requiring Internet access can be found at the books Companion
Website at http://www.prenhall.com/gitman. In the course of completing the assignments students access
information about a firm, its industry, and the macro economy, and conduct analyses consistent with those
found in each respective chapter.