After reading this chapter, students should be able to:

Explain what is meant by a firms weighted average cost of capital.

Define and calculate the component costs of debt and preferred stock.
Explain why retained earnings are not free and use three approaches to
estimate the component cost of retained earnings.
riefly explain why the cost of new e!uity is higher than the cost of
retained earnings, calculate the cost of new e!uity, and calculate the
retained earnings breakpoint""which is the point where new e!uity would
have to be issued.
riefly explain the two alternative approaches that can be used to account
for flotation costs.
#alculate the firms composite, or weighted average, cost of capital.
$dentify some of the factors that affect the overall, composite cost of
capital.
riefly explain how firms should evaluate pro%ects with different risks,
and the problems encountered when divisions within the same firm all use
the firms composite &A## when considering capital budgeting pro%ects.
'ist and briefly explain the three separate and distinct types of risk that
can be identified, and explain the procedure many firms use when developing
sub%ective risk"ad%usted costs of capital.
(se the #A)* to directly estimate the cost of capital for specific pro%ects
or divisions.
$dentify and explain the two approaches that have been used to estimate
individual assets betas.
'ist some problem areas in estimating the cost of capital.
Harcourt, Inc. Learning Objectives: 10 - 1
Chapter 10 The Cost of Capital
LEARNING OBJECTIVES
#hapter +, uses the rate of return concepts covered in previous chapters,
along with the concept of the weighted average cost of capital -&A##., to
develop a corporate cost of capital for use in capital budgeting.
&e begin by describing the logic of the &A##, and why it should be used
in capital budgeting. &e next explain how to estimate the cost of each
component of capital, and how to put the components together to determine the
&A##. &e go on to discuss factors that affect the &A##, how to ad%ust the
cost of capital for risk, and estimating pro%ect risk. /hen, we discuss how
to use the #A)* to estimate the risk"ad%usted cost of capital, and we discuss
techni!ues for measuring beta risk. &e conclude the chapter with a discussion
on some problem areas in the cost of capital.
/he details of what we cover, and the way we cover it, can be seen by
scanning Blueprints, #hapter +,. 0or other suggestions about the lecture,
please see the 1'ecture 2uggestions3 in #hapter 4, where we describe how we
conduct our classes.
DA52 67 #8A)/E9: : 60 ;< DA52 -;,"minute periods.
Lecture Suggestions: 10 - 2 Harcourt, Inc.
LECTURE SUGGESTIONS
+,"+ )robable Effect on
k
d
-+ " /. k
s
&A##
a. /he corporate tax rate is lowered. = , =

b. /he 0ederal 9eserve tightens credit. = = =

c. /he firm uses more debt> that is, it
increases its debt?assets ratio. = = ,

d. /he dividend payout ratio is
increased. , , ,

e. /he firm doubles the amount of capital
it raises during the year. , or = , or = , or =

f. /he firm expands into a risky
new area. = = =

g. /he firm merges with another firm
whose earnings are counter"cyclical
both to those of the first firm and
to the stock market. " " "

h. /he stock market falls drastically,
and the firms stock falls along with
the rest. , = =

i. $nvestors become more risk averse. = = =

%. /he firm is an electric utility with a
large investment in nuclear plants.
2everal states propose a ban on
nuclear power generation. = = =

+,"4 eta -market. risk refers to the pro%ects effect on the corporate beta
coefficient. &ithin"firm -corporate. risk refers to the pro%ects
Harcourt, Inc. Answers and Solutions: 10 -
ANS!ERS TO EN"-O#-C$A%TER &UESTIONS
effect on the stability of the firms earnings. 2tand"alone risk refers
to the inherent riskiness of the pro%ects expected returns when viewed
alone. /heoretically, beta -market. risk is the most relevant measure
because of its effect on stock prices.
+,": /he cost of capital for average"risk pro%ects would be the firms cost
of capital, +, percent. A somewhat higher cost would be used for more
risky pro%ects, and a lower cost would be used for less risky ones. 0or
example, we might use +4 percent for more risky pro%ects and @ percent
for less risky pro%ects. /hese choices are arbitrary.
+,"A Each firm has an optimal capital structure, defined as that mix of debt,
preferred, and common e!uity that causes its stock price to be
maximiBed. A value"maximiBing firm will determine its optimal capital
structure, use it as a target, and then raise new capital in a manner
designed to keep the actual capital structure on target over time. /he
target proportions of debt, preferred stock, and common e!uity, along
with the costs of those components, are used to calculate the firms
weighted average cost of capital, &A##.
/he weights could be based either on the accounting values shown on
the firms balance sheet -book values. or on the market values of the
different securities. /heoretically, the weights should be based on
market values, but if a firms book value weights are reasonably close
to its market value weights, book value weights can be used as a proxy
for market value weights. #onse!uently, target market value weights
should be used in the &A## e!uation.
+,"; An increase in the risk"free rate will increase the cost of debt.
9emember from #hapter ;, k C k
90
= D9) = ') = *9). /hus, if k
90
increases so does k -the cost of debt.. 2imilarly, if the risk"free
rate increases so does the cost of e!uity. 0rom the #A)* e!uation, k
s
C
k
90
= -k
*
D k
90
.b. #onse!uently, if k
90
increases k
s
will increase too.
+,"E $n general, failing to ad%ust for differences in risk would lead the
firm to accept too many risky pro%ects and re%ect too many safe ones.
6ver time, the firm would become more risky, its &A## would increase,
and its shareholder value would suffer.
Answers and Solutions: 10 - ' Harcourt, Inc.
+,"+ A,F Debt> E,F E!uity> k
d
C @F> / C A,F> &A## C @.@EF> k
s
C G
&A## C -w
d
.-k
d
.-+ " /. = -w
c
.-k
s
.
,.,@@E C -,.A.-,.,@.-+ " ,.A. = -,.E.k
s
,.,@@E C ,.,4+E = ,.Ek
s
,.,H< C ,.Ek
s
k
s
C +:F.
+,"4 )
p
C IAH.;,> D
p
C I:.<,> k
p
C G
k
p
C
)
D
p
p
k
p
C
IAH.;,
I:.<,
C <F.
+,": )
,
C I:,> D
+
C I:.,,> g C ;F> 0 C +,F> k
s
C G> k
e
C G
k
s
C
,
+
)
D
= g C
I:,.,,
I:.,,
= ,.,; C +;F.
k
e
C
. 0 + - )
D

,
+

= g C
,.+,. " I:,-+
I:.,,
= ,.,;
C
I4H.,,
I:.,,
= ,.,; C +E.++F.
+,"A )ro%ects A, , #, D, and E would be accepted since each pro%ects return
is greater than the firms &A##.
+,"; a. k
d
-+ " /. C +:F-+ " ,. C +:.,,F.
b. k
d
-+ " /. C +:F-,.<,. C +,.A,F.
c. k
d
-+ " /. C +:F-,.E;. C <.A;F.
+,"E k
d
-+ " /. C ,.+4-,.E;. C H.<,F.
Harcourt, Inc. Answers and Solutions: 10 - (
SOLUTIONS TO EN"-O#-C$A%TER %ROBLE)S
+,"H k
p
C
I@4.+;
I+,,-,.++.
C
I@4.+;
I++
C ++.@AF.
+,"< a. k
s
C
,
+
)
D
= g
k
s
C ,.,E =
I:E
I:.+<
k
s
C +A.<:F.
b. 0 C -I:E.,, " I:4.A,.?I:E.,, C I:.E,?I:E.,, C +,F.
c. k
e
C D
+
?J)
,
-+ " 0.K = g C I:.+<?I:4.A, = EF C @.<+F = EF C +;.<+F.
+,"@ #apital 2ources Amount #apital 2tructure &eight
'ong"term debt I+,+;4 A,.,F
E!uity +,H4< E,.,
I4,<<, +,,.,F
&A## C w
d
k
d
-+ " /. = w
c
k
s
C ,.A-,.+:.-,.E. = ,.E-,.+E.
C ,.,:+4 = ,.,@E, C +4.H4F.
+,"+, k
s
C D
+
?)
,
= g C I4-+.,H.?I4A.H; = HF
C <.E;F = HF C +;.E;F.
&A## C w
d
-k
d
.-+ " /. = w
c
-k
s
.> w
c
C + " w
d
.
+:.@;F C w
d
-++F.-+ " ,.:;. = -+ " w
d
.-+;.E;F.
,.+:@; C ,.,H+;w
d
= ,.+;E; " ,.+;E;w
d
",.,+H C ",.,<;w
d
w
d
C ,.4, C 4,F.
+,"++ a. k
d
C +,F, k
d
-+ " /. C +,F-,.E. C EF.
D?A C A;F> D
,
C I4> g C AF> )
,
C I4,> / C A,F.
)ro%ect A: 9ate of return C +:F.
)ro%ect : 9ate of return C +,F.
k
s
C I4-+.,A.?I4, = AF C +A.A,F.
b. &A## C ,.A;-EF. = ,.;;-+A.A,F. C +,.E4F.
c. 2ince the firms &A## is +,.E4F and each of the pro%ects is e!ually
risky and as risky as the firms other assets, *E# should accept
)ro%ect A. $ts rate of return is greater than the firms &A##.
)ro%ect should not be accepted, since its rate of return is less
than *E#s &A##.
Answers and Solutions: 10 - * Harcourt, Inc.
+,"+4 Enter these values: 7 C E,, )L C ";+;.+E, )*/ C :,, and 0L C +,,,, to
get $ C EF C periodic rate. /he nominal rate is EF-4. C +4F, and the
after"tax component cost of debt is +4F-,.E. C H.4F.
+,"+: Debt C A,F, E!uity C E,F.
)
,
C I44.;,, D
,
C I4.,,, D
+
C I4.,,-+.,H. C I4.+A, g C HF.
k
s
C
,
+
)
D
= g C
;, . 44 I
+A . 4 I
= HF C +E.;+F.
&A## C -,.A.-,.+4.-+ " ,.A. = -,.E.-,.+E;+.
C ,.,4<< = ,.,@@+ C +4.H@F.
+,"+A a. k
s
C
,
+
)
D
= g C
I4:
I4.+A
= HF C @.:F = HF C +E.:F.
b. k
s
C k
90
= -k
*
" k
90
.b
C @F = -+:F " @F.+.E C @F = -AF.+.E C @F = E.AF C +;.AF.
c. k
s
C ond rate = 9isk premium C +4F = AF C +EF.
d. /he bond"yield"plus"risk"premium approach and the #A)* method both
resulted in lower cost of common stock estimates than the D#0 method.
2ince financial analysts tend to give the most weight to the D#0
method, the firms cost of common stock should be estimated to be
about +E.: percent.
+,"+; a. &ith a financial calculator, input 7 C ;, )L C "A.A4, )*/ C ,, 0L C
E.;,, and then solve for $ C <.,4F <F.
b. D
+
C D
,
-+ = g. C I4.E,-+.,<. C I4.<+.
c. k
s
C D
+
?)
,
= g C I4.<+?I:E.,, = <F C +;.<+F.
+,"+E a. k
s
C
,
+
)
D
= g
,.,@ C
IE,.,,
I:.E,
= g
,.,@ C ,.,E = g
g C :F.
b. #urrent E)2 I;.A,,
'ess: Dividends per share :.E,,
9etained earnings per share I+.<,,
9ate of return ,.,@,
$ncrease in E)2 I,.+E4
)lus: #urrent E)2 ;.A,,
7ext years E)2 I;.;E4
Alternatively, E)2
+
C E)2
,
-+ = g. C I;.A,-+.,:. C I;.;E4.
+,"+H a. After"tax cost of new debt: k
d
-+ " /. C ,.,@-+ " ,.A. C ;.AF.
#ost of common e!uity:
#alculate g as follows:
&ith a financial calculator, input 7 C @, )L C ":.@,, )*/ C ,, 0L C
H.<,, and then solve for $ C <.,+F <F.
k
s
C
,
+
)
D
= g C
IE;.,,
<,. -,.;;.-IH.
= ,.,< C
IE;.,,
IA.4@
= ,.,< C ,.+AE C
+A.EF.
b. &A## calculation:
After"tax &eighted
#omponent &eight #ost C #ost
DebtJ,.,@-+ " /.K ,.A, ;.AF 4.+EF
#ommon e!uity -9E. ,.E, +A.EF <.HEF
+,.@4F
+,"+< a. k
d
-+ " /. C ,.+,-+ " ,.:. C HF.
k
p
C I;?IA@ C +,.4F.
k
s
C I:.;,?I:E = EF C +;.H4F.
b. &A##:
After"tax &eighted
#omponent &eight #ost C #ost
DebtJ,.+,-+ " /.K ,.+; H.,,F +.,;F
)referred stock ,.+, +,.4,F +.,4F
#ommon stock ,.H; +;.H4F ++.H@F
&A## C +:.<EF
c. )ro%ects + and 4 will be accepted since their rates of return exceed
the &A##.
+,"+@ a. beta C w
/D
b
/D
= &
9D
b
9D
C -,.H;.+.; = -,.4;.,.; C +.4;.
/his is the corporate beta.
b. k
s
C k
90
= -k
*
" k
90
.b C @F = -+:F " @F.+.4; C +AF.
c. /he divisional costs of capital are:
k
/D
C @F = AF-+.;. C +;F. k
9D
C @F = AF-,.;. C ++F.
/herefore, for average pro%ects within each division, these rates
would be used. $f a pro%ect were %udged to be more or less risky
than average for the division, these divisional costs of capital
would be increased or decreased.
+,"4, /he detailed solution for the spreadsheet problem is available both on
the instructors resource #D"96* and on the instructors side of the
8arcourt #ollege )ublishers web site:
http:??www.harcourtcollege.com?finance?concise:e.
+,"4+ /he detailed solution for the cyberproblem is available on the
instructors side of the 8arcourt #ollege )ublishers web site:
http:??www.harcourtcollege.com?finance?concise:e.
Computer/Internet Applications: 10 - 10 Harcourt, Inc.
S%REA"S$EET %ROBLE)
C+BER%ROBLE)
Cole,a- Te.h-olo/ies I-.0
Cost of Capital
10-22 COLEMAN TECHNOLOGIES IS CONSIDERING A MAJOR EXPANSION PROGRAM THAT HAS
BEEN PROPOSED BY THE COMPANYS INFORMATION TECHNOLOGY GROUP. BEFORE
PROCEEDING WITH THE EXPANSION, THE COMPANY NEEDS TO DEVELOP AN
ESTIMATE OF ITS COST OF CAPITAL. ASSUME THAT YOU ARE AN ASSISTANT TO
JERRY LEHMAN, THE FINANCIAL VICE-PRESIDENT. YOUR FIRST TAS IS TO
ESTIMATE COLEMANS COST OF CAPITAL. LEHMAN HAS PROVIDED YOU WITH THE
FOLLOWING DATA, WHICH HE BELIEVES MAY BE RELEVANT TO YOUR TAS!
1. THE FIRMS TAX RATE IS "0 PERCENT.
2. THE CURRENT PRICE OF COLEMANS 12 PERCENT COUPON, SEMIANNUAL
PAYMENT, NONCALLABLE BONDS WITH 1# YEARS REMAINING TO MATURITY IS
$1,1#%.&2. COLEMAN DOES NOT USE SHORT-TERM INTEREST-BEARING DEBT ON
A PERMANENT BASIS. NEW BONDS WOULD BE PRIVATELY PLACED WITH NO
FLOTATION COST.
%. THE CURRENT PRICE OF THE FIRMS 10 PERCENT, $100 PAR VALUE,
'UARTERLY DIVIDEND, PERPETUAL PREFERRED STOC IS $111.10.
". COLEMANS COMMON STOC IS CURRENTLY SELLING AT $#0 PER SHARE. ITS
LAST DIVIDEND (D
0
) WAS $".1*, AND DIVIDENDS ARE EXPECTED TO GROW AT
A CONSTANT RATE OF # PERCENT IN THE FORESEEABLE FUTURE. COLEMANS
BETA IS 1.2, THE YIELD ON T-BONDS IS & PERCENT, AND THE MARET RIS
PREMIUM IS ESTIMATED TO BE + PERCENT. FOR THE BOND-YIELD-PLUS-
RIS-PREMIUM APPROACH, THE FIRM USES A " PERCENTAGE POINT RIS
PREMIUM.
#. COLEMANS TARGET CAPITAL STRUCTURE IS %0 PERCENT LONG-TERM DEBT, 10
PERCENT PREFERRED STOC, AND +0 PERCENT COMMON E'UITY.
TO STRUCTURE THE TAS SOMEWHAT, LEHMAN HAS ASED YOU TO ANSWER THE
FOLLOWING 'UESTIONS.
Harcourt, Inc. Integrated Case: 10 - 11
INTEGRATE" CASE
Integrated Case: 10 - 12 Harcourt, Inc.
A. 1. WHAT SOURCES OF CAPITAL SHOULD BE INCLUDED WHEN YOU ESTIMATE COLEMANS
WEIGHTED AVERAGE COST OF CAPITAL (WACC),
ANSWER! J286& 2+,"+ /896(M8 2+,": 8E9E.K /8E &A## $2 (2ED )9$*A9$'5 069
*AN$7M '67M"/E9* #A)$/A' $7LE2/*E7/ DE#$2$672, i.e., 069 #A)$/A'
(DME/$7M. /8(2, /8E &A## 286('D $7#'(DE /8E /5)E2 60 #A)$/A' (2ED /6
)A5 069 '67M"/E9* A22E/2, A7D /8$2 $2 /5)$#A''5 '67M"/E9* DE/,
)9E0E99ED 2/6#N -$0 (2ED., A7D #6**67 2/6#N. 2869/"/E9* 26(9#E2 60
#A)$/A' #672$2/ 60
-+. 2)67/A7E6(2, 767$7/E9E2/"EA9$7M '$A$'$/$E2 2(#8 A2 A##6(7/2
)A5A'E A7D A##9(A'2 A7D -4. 2869/"/E9* $7/E9E2/"EA9$7M DE/, 2(#8 A2
76/E2 )A5A'E. $0 /8E 0$9* (2E2 2869/"/E9* $7/E9E2/"EA9$7M DE/ /6
A#O($9E 0$PED A22E/2 9A/8E9 /8A7 Q(2/ /6 0$7A7#E &69N$7M #A)$/A'
7EED2, /8E7 /8E &A## 286('D $7#'(DE A 2869/"/E9* DE/ #6*)67E7/.
767$7/E9E2/"EA9$7M DE/ $2 ME7E9A''5 76/ $7#'(DED $7 /8E #62/ 60
#A)$/A' E2/$*A/E E#A(2E /8E2E 0(7D2 A9E 7E//ED 6(/ &8E7 DE/E9*$7$7M
$7LE2/*E7/ 7EED2, /8A/ $2, 7E/ 6)E9A/$7M 9A/8E9 /8A7 M9622 6)E9A/$7M
&69N$7M #A)$/A' $2 $7#'(DED $7 #A)$/A' EP)E7D$/(9E2.
A. 2. SHOULD THE COMPONENT COSTS BE FIGURED ON A BEFORE-TAX OR AN AFTER-TAX
BASIS,
ANSWER! J286& 2+,"A 8E9E.K 2/6#N86'DE92 A9E #67#E97ED )9$*A9$'5 &$/8 /862E
#69)69A/E #A28 0'6&2 /8A/ A9E ALA$'A'E 069 /8E$9 (2E, 7A*E'5, /862E
#A28 0'6&2 ALA$'A'E /6 )A5 D$L$DE7D2 69 069 9E$7LE2/*E7/. 2$7#E
D$L$DE7D2 A9E )A$D 096* A7D 9E$7LE2/*E7/ $2 *ADE &$/8 A0/E9"/AP
D6''A92, A'' #A28 0'6& A7D 9A/E 60 9E/(97 #A'#('A/$672 286('D E D67E
67 A7 A0/E9"/AP A2$2.
A. %. SHOULD THE COSTS BE HISTORICAL (EMBEDDED) COSTS OR NEW (MARGINAL)
COSTS,
ANSWER! J286& 2+,"; A7D 2+,"E 8E9E.K $7 0$7A7#$A' *A7AME*E7/, /8E #62/ 60
#A)$/A' $2 (2ED )9$*A9$'5 /6 *ANE DE#$2$672 /8A/ $7L6'LE 9A$2$7M 7E&
#A)$/A'. /8(2, /8E 9E'ELA7/ #6*)67E7/ #62/2 A9E /6DA52 *A9M$7A'
#62/2 9A/8E9 /8A7 8$2/69$#A' #62/2.
Harcourt, Inc. Integrated Case: 10 - 1
B. WHAT IS THE MARET INTEREST RATE ON COLEMANS DEBT AND ITS COMPONENT
COST OF DEBT,
ANSWER! J286& 2+,"H /896(M8 2+,"@ 8E9E.K #6'E*A72 +4 )E9#E7/ 67D &$/8 +;
5EA92 /6 *A/(9$/5 $2 #(99E7/'5 2E''$7M 069 I+,+;:.H4. /8(2, $/2 5$E'D
/6 *A/(9$/5 $2 +, )E9#E7/:
, + 4 :

4@ :,
R R R R R R
"+,+;:.H4

E, E, E,

E, E,


+,,,,
E7/E9 7 C :,, )L C "++;:.H4, )*/ C E,, A7D 0L C +,,,, A7D /8E7 )9E22
/8E $ (//67 /6 0$7D k
d
?4 C $ C ;.,F. 2$7#E /8$2 $2 A 2E*$A77(A' 9A/E,
*('/$)'5 5 4 /6 0$7D /8E A77(A' 9A/E, k
d
C +,F, /8E )9E"/AP #62/ 60
DE/.
2$7#E $7/E9E2/ $2 /AP DED(#/$'E, (7#'E 2A*, $7 E00E#/, )A52 )A9/
60 /8E #62/, A7D #6'E*A72 9E'ELA7/ #6*)67E7/ #62/ 60 DE/ $2 /8E
A0/E9"/AP #62/:
k
d
-+ " /. C +,.,F-+ " ,.A,. C +,.,F-,.E,. C E.,F.
OPTIONAL 'UESTION
SHOULD YOU USE THE NOMINAL COST OF DEBT OR THE EFFECTIVE ANNUAL COST,
ANSWER! 6(9 +, )E9#E7/ )9E"/AP E2/$*A/E $2 /8E 76*$7A' #62/ 60 DE/. 2$7#E /8E
0$9*2 DE/ 8A2 2E*$A77(A' #6()672, $/2 E00E#/$LE A77(A' 9A/E $2 +,.4;
)E9#E7/:
-+.,;.
4
" +., C +.+,4; " +., C ,.+,4; C +,.4;F.
86&ELE9, 76*$7A' 9A/E2 A9E ME7E9A''5 (2ED. /8E 9EA267 $2 /8A/ /8E
#62/ 60 #A)$/A' $2 (2ED $7 #A)$/A' (DME/$7M, A7D #A)$/A' (DME/$7M
#A28 0'6&2 A9E ME7E9A''5 A22(*ED /6 6##(9 A/ 5EA9"E7D. /8E9E069E,
(2$7M 76*$7A' 9A/E2 *ANE2 /8E /9EA/*E7/ 60 /8E #A)$/A' (DME/$7M
D$2#6(7/ 9A/E A7D #A28 0'6&2 #672$2/E7/.
C. 1. WHAT IS THE FIRMS COST OF PREFERRED STOC,
Integrated Case: 10 - 1' Harcourt, Inc.
ANSWER! J286& 2+,"+, /896(M8 2+,"+: 8E9E.K 2$7#E /8E )9E0E99ED $22(E $2
)E9)E/(A', $/2 #62/ $2 E2/$*A/ED A2 06''6&2:
F. , . @ ,@, . ,
+, . +++ I
+, I
+, . +++ I
. +,, -I + . ,
)
D
k

p
p
p
= = = = =
76/E -+. /8A/ 2$7#E )9E0E99ED D$L$DE7D2 A9E 76/ /AP DED(#/$'E /6 /8E
$22(E9, /8E9E $2 76 7EED 069 A /AP ADQ(2/*E7/, A7D -4. /8A/ &E #6('D
8ALE E2/$*A/ED /8E E00E#/$LE A77(A' #62/ 60 /8E )9E0E99ED, (/ A2 $7
/8E #A2E 60 DE/, /8E 76*$7A' #62/ $2 ME7E9A''5 (2ED.
C. 2. COLEMANS PREFERRED STOC IS RISIER TO INVESTORS THAN ITS DEBT, YET
THE PREFERREDS YIELD TO INVESTORS IS LOWER THAN THE YIELD TO MATURITY
ON THE DEBT. DOES THIS SUGGEST THAT YOU HAVE MADE A MISTAE, (HINT!
THIN ABOUT TAXES.)
ANSWER! J286& 2+,"+A /896(M8 2+,"+E 8E9E.K #69)69A/E $7LE2/692 6&7 *62/
)9E0E99ED 2/6#N, E#A(2E H, )E9#E7/ 60 )9E0E99ED D$L$DE7D2 9E#E$LED 5
#69)69A/$672 A9E 767/APA'E. /8E9E069E, )9E0E99ED 60/E7 8A2 A '6&E9
E069E"/AP 5$E'D /8A7 /8E E069E"/AP 5$E'D 67 DE/ $22(ED 5 /8E 2A*E
#6*)A75. 76/E, /86(M8, /8A/ /8E A0/E9"/AP 5$E'D /6 A #69)69A/E
$7LE2/69 A7D /8E A0/E9"/AP #62/ /6 /8E $22(E9 A9E 8$M8E9 67 )9E0E99ED
2/6#N /8A7 67 DE/.
D. 1. WHY IS THERE A COST ASSOCIATED WITH RETAINED EARNINGS,
ANSWER! J286& 2+,"+H /896(M8 2+,"+@ 8E9E.K #6'E*A72 EA97$7M2 #A7 E$/8E9 E
9E/A$7ED A7D 9E$7LE2/ED $7 /8E (2$7E22 69 )A$D 6(/ A2 D$L$DE7D2. $0
EA97$7M2 A9E 9E/A$7ED, #6'E*A72 28A9E86'DE92 069M6 /8E 6))69/(7$/5 /6
9E#E$LE #A28 A7D /6 9E$7LE2/ $/ $7 2/6#N2, 67D2, 9EA' E2/A/E, A7D /8E
'$NE. /8(2, #6'E*A7 286('D EA97 67 $/2 9E/A$7ED EA97$7M2 A/ 'EA2/ A2
*(#8 A2 $/2 2/6#N86'DE92 /8E*2E'LE2 #6('D EA97 67 A'/E97A/$LE
$7LE2/*E7/2 60 EO($LA'E7/ 9$2N. 0(9/8E9, /8E #6*)A752 2/6#N86'DE92
#6('D $7LE2/ $7 #6'E*A72 6&7 #6**67 2/6#N, &8E9E /8E5 #6('D EP)E#/ /6
EA97 k
s
. &E #67#'(DE /8A/ 9E/A$7ED EA97$7M2 8ALE A7 6))69/(7$/5 #62/
/8A/ $2 EO(A' /6 k
s
, /8E 9A/E 60 9E/(97 $7LE2/692 EP)E#/ 67 /8E 0$9*2
#6**67 2/6#N.
Harcourt, Inc. Integrated Case: 10 - 1(
D. 2. WHAT IS COLEMANS ESTIMATED COST OF COMMON E'UITY USING THE CAPM
APPROACH,
ANSWER! J286& 2+,"4, A7D 2+,"4+ 8E9E.K /8E #A)* E2/$*A/E 069 #6'E*A72 #62/
60 #6**67 EO($/5 $2 +A.4 )E9#E7/:
k
s
C k
90
= -k
*
" k
90
.b C H.,F = -E.,F.+.4 C H.,F = H.4F C +A.4F.
E. WHAT IS THE ESTIMATED COST OF COMMON E'UITY USING THE DISCOUNTED CASH
FLOW (DCF) APPROACH,
ANSWER! J286& 2+,"44 /896(M8 2+,"4; 8E9E.K 2$7#E #6'E*A7 $2 A #672/A7/ M96&/8
2/6#N, /8E #672/A7/ M96&/8 *6DE' #A7 E (2ED:
s
k C
s
k
S
C ,; . ,
;, I
. ,; . + - +@ . A I
)
. g + - D
g
)
D
,

,
,
+
+ +
+
= +
C F. < . +: F , . ; F < . < ,; . , ,<< . , ,; . ,
;, I
A, . A I
= + = + = +
F. WHAT IS THE BOND-YIELD-PLUS-RIS-PREMIUM ESTIMATE FOR COLEMANS COST
OF COMMON E'UITY,
ANSWER! J286& 2+,"4E 8E9E.K /8E 67D"5$E'D")'(2"9$2N")9E*$(* E2/$*A/E $2
+A )E9#E7/:
k
s
C 67D 5$E'D = 9$2N )9E*$(* C +,.,F = A.,F C +A.,F.
76/E /8A/ /8E 9$2N )9E*$(* 9EO($9ED $7 /8$2 *E/86D $2 D$00$#('/ /6
E2/$*A/E, 26 /8$2 A))96A#8 67'5 )96L$DE2 A A'')A9N E2/$*A/E 60 k
s
.
$/ $2 (2E0(', /86(M8, A2 A #8E#N 67 /8E D#0 A7D #A)* E2/$*A/E2, &8$#8
#A7, (7DE9 #E9/A$7 #$9#(*2/A7#E2, )96D(#E (79EA267A'E E2/$*A/E2.
G. WHAT IS YOUR FINAL ESTIMATE FOR -
.
,
ANSWER! J286& 2+,"4H 8E9E.K /8E 06''6&$7M /A'E 2(**A9$TE2 /8E k
s
E2/$*A/E2:
*E/86D E2/$*A/E
#A)* +A.4F
D#0 +:.<
Integrated Case: 10 - 1* Harcourt, Inc.
k
d
= 9) +A.,
ALE9AME +A.,F
A/ /8$2 )6$7/, #672$DE9A'E Q(DM*E7/ $2 9EO($9ED. $0 A *E/86D $2
DEE*ED /6 E $70E9$69 D(E /6 /8E 1O(A'$/53 60 $/2 $7)(/2, /8E7 $/
*$M8/ E M$LE7 '$//'E &E$M8/ 69 ELE7 D$29EMA9DED. $7 6(9 EPA*)'E,
/86(M8, /8E /89EE *E/86D2 )96D(#ED 9E'A/$LE'5 #'62E 9E2('/2, 26 &E
DE#$DED /6 (2E /8E ALE9AME, +A )E9#E7/, A2 6(9 E2/$*A/E 069 #6'E*A72
#62/ 60 #6**67 EO($/5.
H. EXPLAIN IN WORDS WHY NEW COMMON STOC HAS A HIGHER PERCENTAGE COST
THAN RETAINED EARNINGS.
ANSWER! J286& 2+,"4< 8E9E.K /8E #6*)A75 $2 9A$2$7M *67E5 $7 69DE9 /6 *ANE A7
$7LE2/*E7/. /8E *67E5 8A2 A #62/, A7D /8$2 #62/ $2 A2ED )9$*A9$'5 67
/8E $7LE2/692 9EO($9ED 9A/E 60 9E/(97, #672$DE9$7M 9$2N A7D A'/E97"
A/$LE $7LE2/*E7/ 6))69/(7$/$E2. 26, /8E 7E& $7LE2/*E7/ *(2/ )96L$DE A
9E/(97 A/ 'EA2/ EO(A' /6 /8E $7LE2/692 6))69/(7$/5 #62/.
$0 /8E #6*)A75 9A$2E2 #A)$/A' 5 2E''$7M 2/6#N, /8E #6*)A75 D6E27/
ME/ A'' 60 /8E *67E5 /8A/ $7LE2/692 )(/ (). 069 EPA*)'E, $0 $7LE2/692
)(/ () I+,,,,,,, A7D $0 /8E5 EP)E#/ A +; )E9#E7/ 9E/(97 67 /8A/
I+,,,,,,, /8E7 I+;,,,, 60 )960$/2 *(2/ E ME7E9A/ED. (/ $0 0'6/A/$67
#62/2 A9E 4, )E9#E7/ -I4,,,,,., /8E7 /8E #6*)A75 &$'' 9E#E$LE 67'5
I<,,,,, 60 /8E I+,,,,,, $7LE2/692 )(/ (). /8A/ I<,,,,, *(2/ /8E7
)96D(#E A I+;,,,, )960$/, 69 A I+;?I<, C +<.H;F 9A/E 60 9E/(97 LE92(2
A +; )E9#E7/ 9E/(97 67 EO($/5 9A$2ED A2 9E/A$7ED EA97$7M2.
I. 1. WHAT ARE TWO APPROACHES THAT CAN BE USED TO ACCOUNT FOR FLOTATION
COSTS,
ANSWER! J286& 2+,"4@ 8E9E.K /8E 0$92/ A))96A#8 $2 /6 $7#'(DE /8E 0'6/A/$67
#62/2 A2 )A9/ 60 /8E )96QE#/ 2 ()"0967/ #62/. /8$2 9ED(#E2 /8E
)96QE#/ 2 E2/$*A/ED 9E/(97. /8E 2E#67D A))96A#8 $2 /6 ADQ(2/ /8E #62/
60 #A)$/A' /6 $7#'(DE 0'6/A/$67 #62/2. /8$2 $2 *62/ #6**67'5 D67E 5
$7#69)69A/$7M 0'6/A/$67 #62/2 $7 /8E D#0 *6DE'.
I. 2. COLEMAN ESTIMATES THAT IF IT ISSUES NEW COMMON STOC, THE FLOTATION
COST WILL BE 1# PERCENT. COLEMAN INCORPORATES THE FLOTATION COSTS
Harcourt, Inc. Integrated Case: 10 - 11
INTO THE DCF APPROACH. WHAT IS THE ESTIMATED COST OF NEWLY ISSUED
COMMON STOC, TAING INTO ACCOUNT THE FLOTATION COST,
ANSWER! J286& 2+,":, A7D 2+,":+ 8E9E.K
+;.AF. C ;.,F =
IA4.;,
IA.A,
C
;.,F =
,.+;. " I;,-+
. IA.+@-+.,;
C
g =
0. " -+
)
g. = -+
D
C
k
,
,
e
J. WHAT IS COLEMANS OVERALL, OR WEIGHTED AVERAGE, COST OF CAPITAL
(WACC), IGNORE FLOTATION COSTS.
ANSWER! J286& 2+,":4 8E9E.K #6'E*A72 &A## $2 ++.+ )E9#E7/.
#A)$/A' 2/9(#/(9E #6*)67E7/
&E$M8/2 #62/2 C )96D(#/
,.: EF +.<F
,.+ @ ,.@
,.E +A <.A
+., &A## C ++.+F
&A## C w
d
k
d
-+ " /. = w
p
k
p
= w
c
k
s
C ,.:-+,F.-,.E. = ,.+-@F. = ,.E-+AF. C +.<F = ,.@F = <.AF C
++.+F.
. WHAT FACTORS INFLUENCE COLEMAN S COMPOSITE WACC,
ANSWER! J286& 2+,":: A7D 2+,":A 8E9E.K /8E9E A9E 0A#/692 /8A/ /8E 0$9* #A776/
#67/96' A7D /862E /8A/ /8E5 #A7 #67/96' /8A/ $70'(E7#E &A##.
0A#/692 /8E 0$9* #A776/ #67/96':
'ELE' 60 $7/E9E2/ 9A/E2
/AP 9A/E2
0A#/692 /8E 0$9* #A7 #67/96':
#A)$/A' 2/9(#/(9E )6'$#5
D$L$DE7D )6'$#5
Integrated Case: 10 - 12 Harcourt, Inc.
*A9NE/ #67D$/$672
$7LE2/*E7/ )6'$#5
L. SHOULD THE COMPANY USE THE COMPOSITE WACC AS THE HURDLE RATE FOR EACH
OF ITS PROJECTS,
ANSWER! J286& 2+,":; /896(M8 2+,":H 8E9E.K 76. /8E #6*)62$/E &A## 9E0'E#/2
/8E 9$2N 60 A7 ALE9AME )96QE#/ (7DE9/ANE7 5 /8E 0$9*. /8E9E069E, /8E
&A## 67'5 9E)9E2E7/2 /8E 18(9D'E 9A/E3 069 A /5)$#A' )96QE#/ &$/8
ALE9AME 9$2N. D$00E9E7/ )96QE#/2 8ALE D$00E9E7/ 9$2N2. /8E )96QE#/2
&A## 286('D E ADQ(2/ED /6 9E0'E#/ /8E )96QE#/2 9$2N.
Harcourt, Inc. Integrated Case: 10 - 13
M. WHAT ARE THREE TYPES OF PROJECT RIS, HOW IS EACH TYPE OF RIS USED,
ANSWER! J286& 2+,":< A7D 2+,":@ 8E9E.K /8E /89EE /5)E2 60 )96QE#/ 9$2N A9E:
2/A7D"A'67E 9$2N
#69)69A/E 9$2N
*A9NE/ 9$2N
*A9NE/ 9$2N $2 /8E69E/$#A''5 E2/ $7 *62/ 2$/(A/$672. 86&ELE9,
#9ED$/692, #(2/6*E92, 2())'$E92, A7D E*)'65EE2 A9E *69E A00E#/ED 5
#69)69A/E 9$2N. /8E9E069E, #69)69A/E 9$2N $2 A'26 9E'ELA7/. 2/A7D"
A'67E 9$2N $2 /8E EA2$E2/ /5)E 60 9$2N /6 *EA2(9E.
/AN$7M 67 A )96QE#/ &$/8 A 8$M8 DEM9EE 60 E$/8E9 2/A7D"A'67E 69
#69)69A/E 9$2N &$'' 76/ 7E#E22A9$'5 A00E#/ /8E 0$9*2 *A9NE/ 9$2N.
86&ELE9, $0 /8E )96QE#/ 8A2 8$M8'5 (7#E9/A$7 9E/(972, A7D $0 /862E
9E/(972 A9E 8$M8'5 #699E'A/ED &$/8 9E/(972 67 /8E 0$9*2 6/8E9 A22E/2
A7D &$/8 *62/ 6/8E9 A22E/2 $7 /8E E#676*5, /8E )96QE#/ &$'' 8ALE A
8$M8 DEM9EE 60 A'' /5)E2 60 9$2N.
N. WHAT PROCEDURES ARE USED TO DETERMINE THE RIS-ADJUSTED COST OF
CAPITAL FOR A PARTICULAR PROJECT OR DIVISION, WHAT APPROACHES ARE
USED TO MEASURE A PROJECTS BETA,
ANSWER! J286& 2+,"A, /896(M8 2+,"A4 8E9E.K /8E 06''6&$7M )96#ED(9E2 #A7 E
(2ED /6 DE/E9*$7E A )96QE#/2 9$2N"ADQ(2/ED #62/ 60 #A)$/A':
2(QE#/$LE ADQ(2/*E7/2 /6 /8E 0$9*2 #6*)62$/E &A##.
A//E*)/ /6 E2/$*A/E &8A/ /8E #62/ 60 #A)$/A' &6('D E $0 /8E
)96QE#/?D$L$2$67 &E9E A 2/A7D"A'67E 0$9*. /8$2 9EO($9E2 E2/$*A/$7M
/8E )96QE#/2 E/A.
/8E 06''6&$7M A))96A#8E2 #A7 E (2ED /6 *EA2(9E A )96QE#/2 E/A:
)(9E )'A5 A))96A#8. 0$7D 2ELE9A' )('$#'5 /9ADED #6*)A7$E2
EP#'(2$LE'5 $7 /8E )96QE#/2 (2$7E22. /8E7, (2E /8E ALE9AME 60
/8E$9 E/A2 A2 A )96P5 069 /8E )96QE#/2 E/A. -$/2 8A9D /6 0$7D
2(#8 #6*)A7$E2..
Integrated Case: 10 - 20 Harcourt, Inc.
A##6(7/$7M E/A A))96A#8. 9(7 A 9EM9E22$67 E/&EE7 /8E )96QE#/2
96A A7D /8E 2U) $7DEP 96A. A##6(7/$7M E/A2 A9E #699E'A/ED -,.; "
,.E. &$/8 *A9NE/ E/A2. 86&ELE9, 56( 769*A''5 #A7/ ME/ DA/A 67
7E& )96QE#/ 96As E069E /8E #A)$/A' (DME/$7M DE#$2$67 8A2 EE7
*ADE.
O. COLEMAN IS INTERESTED IN ESTABLISHING A NEW DIVISION, WHICH WILL FOCUS
PRIMARILY ON DEVELOPING NEW INTERNET-BASED PROJECTS. IN TRYING TO
DETERMINE THE COST OF CAPITAL FOR THIS NEW DIVISION, YOU DISCOVER THAT
STAND-ALONE FIRMS INVOLVED IN SIMILAR PROJECTS HAVE ON AVERAGE THE
FOLLOWING CHARACTERISTICS!
THEIR CAPITAL STRUCTURE IS "0 PERCENT DEBT AND +0 PERCENT COMMON
E'UITY.
THEIR COST OF DEBT IS TYPICALLY 12 PERCENT.
THE BETA IS 1.&.
GIVEN THIS INFORMATION, WHAT WOULD YOUR ESTIMATE BE FOR THE DIVISIONS
COST OF CAPITAL,
ANSWER! J286& 2+,"A: /896(M8 2+,"A; 8E9E.K
k
s D$L.
C k
90
= -k
*
" k
90
.b
D$L.
C HF = -EF.+.H C +H.4F.
&A##
D$L.
C &
d
k
d
-+ " /. = &
c
k
s
C ,.A-+4F.-,.E. = ,.E-+H.4F.
C +:.4F.
/8E D$L$2$672 &A## C +:.4F L2. /8E #69)69A/E &A## C ++.+F. /8E
D$L$2$672 *A9NE/ 9$2N $2 M9EA/E9 /8A7 /8E 0$9*2 ALE9AME )96QE#/2.
/5)$#A' )96QE#/2 &$/8$7 /8$2 D$L$2$67 &6('D E A##E)/ED $0 /8E$9
9E/(972 &E9E A6LE +:.4 )E9#E7/.
Harcourt, Inc. Integrated Case: 10 - 21