Solutions to Chapter 12

The Cost of Capital

1.

The yield to maturity for the bonds (since maturity is now 19 years) is the interest
rate (r) that is the solution to the following equation:
[$80 annuity factor(r, 19 years)] + [$1,000/(1 + r) 19] = $1,050
Using a financial calculator, enter: n = 19, FV = 1000, PV = (-)1050, PMT = 90, and
then compute i = 7.50%
Therefore, the after-tax cost of debt is: 7.50% (1 0.35) = 4.88%

2.

r = DIV/P0 = $4/$40 = 0.10 = 10%

3.

WACC
rdebt (1 TC )
rpreferred
requity
V
V
V

= [0.3 7.50% (1 0.35)] + [0.2 10%] + [0.5 12.0%] = 9.46%

DIV0 (1 g)
DIV1
$5 1.05
g
g
0.05 0.1375 13.75%
P0
P0
$60

4.

5.

The total value of the firm is $80 million. The weights for each security class are as
follows:
Debt:
Preferred:
Common:

D/V = 20/80 = 0.250

P/V = 10/80 = 0.125
E/V = 50/80 = 0.625

WACC
rdebt (1 TC )
rpreferred
requity
V
V
V

= [0.250 6% (1 0.35)] + [0.125 8%] + [0.625 12.0%] = 9.475%

6.

Executive Fruit should use the WACC of Geothermal, not its own WACC,
when evaluating an investment in geothermal power production. The risk of
the project determines the discount rate, and in this case, Geothermals
WACC is more reflective of the risk of the project in question. The proper
discount rate, therefore, is not 12.3%. It is more likely to be 11.4%.

7.

The flotation costs reduce the NPV of the project by $1.2 million. Even so,
project NPV is still positive, so the project should be undertaken.

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12-2

8.

The rate on Buildwells debt is 5 percent. The cost of equity capital is the required rate
of return on equity, which can be calculated from the CAPM as follows:
4% + (0.90 8%) = 11.2%
The weighted average cost of capital, with a tax rate of zero, is:
D

WACC
rdebt (1 TC )
requity
V

= [0.30 5% (1 0)] + [0.70 11.2%] = 9.34%

9.

The internal rate of return, which is 12%, exceeds the cost of capital. Therefore,
BCCI should accept the project.
The present value of the project cash flows is:
$100,000 annuity factor(9.34%, 8 years) = $546,556.08
This is the most BCCI should pay for the project.

10.
Security
Debt
Equity
Total

Market Value
$ 5.5 million
$15.0 million
$20.5 million

*Number of shares =

Explanation
1.10 par value of $5 million
$30 per share 500,000 shares *

$10 million book value

500,000
$20 book value per share

WACC
rdebt (1 TC )
requity
V

5.5
15

9% (1 0.40)
15% 12.42%
20
.
5
20
.
5

11. Since the firm is all-equity financed: asset beta = equity beta = 0.8
The WACC is the same as the cost of equity, which can be calculated using the
CAPM:
requity = rf + (rm rf) = 4% + (0.80 10%) = 12%
12.

The 12.5% value calculated by the analyst is the current yield of the firms outstanding
debt: interest payments/bond value. This calculation ignores the fact that bonds selling at
discounts from, or premiums over, par value provide expected returns determined in part
by expected price appreciation or depreciation. The analyst should be using yield to
maturity instead of current yield to calculate cost of debt. [This answer assumes the value
of the debt provided is the market value. If it is the book value, then 12.5% would be the

12-3

average coupon rate of outstanding debt, which would also be a poor estimate of the
required rate of return on the firms debt.]
13.

a.

Using the recent growth rate of 30% and the dividend yield of 2%, one estimate
would be:
DIV1/P0 + g = 0.02 + 0.30 = 0.32 = 32%
Another estimate, based on the CAPM, would be:
r = rf + (rm rf) = 4% + (1.2 8%) = 13.6%

14.

b.

The estimate of 32% seems far less reasonable. It is based on an historic growth rate
that is impossible to sustain. The [DIV1/P0 + g] rule requires that the growth rate of
dividends per share must be viewed as highly stable over the foreseeable future. In
other words, it requires the use of the sustainable growth rate.

a.

The 9% coupon bond has a yield to maturity of 10% and sells for 93.86% of face
value:
n = 10, i = 10%, PMT = 90, FV = 1000, compute PV = $938.55
Therefore, the market value of the issue is:
0.9386 $20 million = $18.77 million
The 10% coupon bond sells for 94% of par value, and has a yield to maturity
of 10.83%:
n = 15, PV = ()940, PMT = 100, FV = 1000, compute i = 10.83%
The market value of the issue is:
0.94 $25 million = $23.50 million
Therefore, the weighted-average before-tax cost of debt is:

18.77
23.50

18.77 23.50 10% 18.77 23.50 10.83% 10.46%

b.
15.

The after-tax cost of debt is: (1 0.35) 10.46% = 6.80%

The bonds are selling below par value because the yield to maturity is greater than
the coupon rate.
The price per $1,000 par value is:
[$80 annuity factor(9%, 10 years)] + ($1,000/1.0910) = $935.82
The total market value of the bonds is:

12-4

$10 million par value

$935.82 market value

$9.36 million
$1,000 par value

There are: $2 million/$20 = 100,000 shares of preferred stock.

The market price of the preferred stock is $15 per share, so that the total market
value of the preferred stock is $1.5 million.

12-5

There are: $0.1 million/$0.10 = 1 million shares of common stock.

The market price of the common stock is $20 per share, so that the total market
value of the common stock is $20 million.
Therefore, the capital structure is:
Security
Bonds
Preferred Stock
Common Stock
Total
16.

Market Value
$ 9.36 million
$ 1.50 million
$20.00 million
$30.86 million

Percent
30.3%
4.9%
64.8%
100.0%

The yield to maturity for the firms debt is: rdebt = 9%

The rate for the preferred stock is: rpreferred = $2/$15 = 0.1333 = 13.33%
The rate for the common stock is:
requity = rf + (rm rf) = 6% + 0.8 10% = 14%
Using the capital structure derived in the previous problem, we can calculate WACC as:
D

WACC
rdebt (1 TC )
rpreferred
requity
V

= [0.303 9% (1 0.40)] + [0.049 13.33%] + [0.648 14%] = 11.36%

17.

The IRR on the computer project is less than the WACC of firms in the computer industry.
Therefore, the project should be rejected. However, the WACC of the firm (based on its
existing mix of projects) is only 11.36%. If the firm uses this figure as the hurdle rate, it
will incorrectly go ahead with the venture in home computers.

18.

a.

r = rf + (rm rf) r = 4% + (1.2 10%) = 16%

b.

Weighted average beta = (0.4 0) + (0.6 1.5) = 0.9

c.

WACC
rdebt (1 TC )
requity
V

= [0.4 4% (1 0.4)] + [0.6 16%] = 10.56%

d.

If the company plans to expand its present business, then the WACC is a
reasonable estimate of the discount rate since the risk of the proposed project
is similar to the risk of the existing projects. Use a discount rate of 10.56%.

e.

The WACC of optical projects should be based on the risk of those projects.
Using a beta of 1.4, the discount rate for the new venture is:
r = 4% + 1.4 10% = 18%

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12-7

19.

If Big Oil does not pay taxes, then the after-tax and before-tax costs of debt are
identical. WACC would then become:
D

WACC
rdebt (1 TC )
requity
V
V

= [0.243 9% (1 0)] + [0.757 12.8%] = 11.88%

If Big Oil issues new equity and uses the proceeds to pay off all of its debt, the
cost of equity will decrease. There is no longer any leverage, so the equity
becomes safer and therefore commands a lower risk premium. In fact, with allequity financing, the cost of equity would be the same as the firms WACC, which
is 11.88%. This is less than the previous value of 12.8%. (We use the WACC
derived in the absence of interest tax shields since, for the all-equity firm, there is
no interest tax shield.)
20.

The net effect of Big Oils transaction is to leave the firm with $200 million more
debt (because of the borrowing) and $200 million less equity (because of the
dividend payout). Total assets and business risk are unaffected. The WACC will
remain unchanged because business risk is unchanged. However, the cost of equity
will increase. With the now higher leverage, the business risk is spread over a
smaller equity base, so each share is now riskier.
The new financing mix for the firm is: E = $1,000 and D = $585.7
Therefore:
D
$585.7
E
$1,000

0.369 and

0.631
V
$1,585.7
V
$1,585.7

If the cost of debt is still 9%, then we solve for the new cost of equity as follows.
Use the fact that, even at the new financing mix, WACC must still be 12.41%.
D

WACC
rdebt (1 TC )
requity
V

= [0.369 9% (1 0)] + [0.631 r equity] = 12.41%

We solve to find that: requity = 13.56%
21.

Even if the WACC were lower when the firms tax rate is higher, this does not imply that
the firm would be worth more. The after-tax cash flows the firm would generate for its
owners would also be lower. This would reduce the value of the firm even if the cash
flows were discounted at a lower rate. If the tax authority is collecting more income from
the firm, the value of the firm will fall.

22.

This reasoning is faulty in that it implicitly treats the discount rate for the project as the
cost of debt if the project is debt financed, and as the cost of equity if the project is equity
financed. In fact, if the project poses risk comparable to the risk of the firms other

12-8

projects, the proper discount rate is the firms cost of capital, which is a weighted average
of the costs of both debt and equity.

12-9

Solution to Minicase for Chapter 12

Bernice needs to explain to her boss, Mr. Brinestone, that appropriate rates of return for
cost of capital calculations are the rates of return that investors can earn on comparable
risk investments in the capital market. Mr. Brinestones estimate of the cost of equity is
his target value for the book return on equity; it is not the expected rate of return that
investors demand on shares of stock with the same risk as Sea Shore Salt.
Bernices CAPM calculation indicates that the correct value for the equity rate is 11%.
This value is broadly consistent with the rate one would infer from the constant growth
dividend discount model (which seems appropriate for a mature firm like this one with
stable growth prospects). The dividend discount model implies a cost of equity of a bit
more than 11 percent:
requity

DIV1
$2
g
0.067 0.117 11.7%
P0
$40

Thus, it appears that Bernices calculation is correct.

Similarly, Mr. Brinestones returns for other securities should be modified to reflect the
expected returns these securities currently offer to investors. The bank loan and bond
issue offer pre-tax rates of 8% and 7.75%, respectively, as in Mr. Brinestones memo. The
preferred stock, however, is not selling at par, so Mr. Brinestones assertion that the rate
of return on preferred is 6% is incorrect. In fact, with the preferred selling at $70 per
share, the rate of return is:
rpreferred

DIV
P0

$6
0.086 8.6%
$70

This makes sense: the pre-tax return on preferred should exceed that on the firms debt.
Finally, the weights used to calculate the WACC should reflect market, not book, values.
These are the prices that investors would pay to acquire the securities. The market value
weights are computed as follows:
Comment
Bank loan
Bond issue
Preferred stock
Common stock

valued at face amount

valued at par
$70 1 million shares
$40 10 million shares

Amount
(millions)
$120
80
70
400
$670

Percent of
total
17.91
11.94
10.45
59.70
100.00

Rate of
return (%)
8.00
7.75
8.60
11.00

Therefore, the WACC, which serves as the corporate hurdle rate, should be 9%:
WACC = [0.1791 8% (1 0.35)] + [0.1194 7.75% (1 0.35)]
+ (0.1045 8.6%) + (0.5970 11%) = 9.00%

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