Cost of Capital
Answers to Warm-Up Exercises
E9-1. Answer: Weighted average cost of capital N 10, PV $20,000 (1 0.02) $19,600, PMT Solve for I 8.30% 0.08 $20,000 $1,600, FV $20,000
E9-2. Cost of preferred stock Answer: The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock. rp Dp Np rp (0.15 $35) ($35 $3) rp $5.25 $32 16.4% E9-3. Cost of common stock equity Answer: The cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current price of the stock and adding the expected growth rate. rs (D1 P0) g rs ($6.50 $78) 7% 15.33% E9-4. Weighted average cost of capital (0.35 0.08) (0.65 0.13) 0.0280 (0.35 0.0845 0.106) 11.25% 0.0832 8.32% Answer: ra
E9-5. Weighted average cost of capital Answer: ra (0.55 0.067) (0.10 0.092)
Solutions to Problems
P9-1. Concept of cost of capital LG 1; Basic a. The firm is basing its decision on the cost to finance a particular project rather than the firm’s combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions. ra wd rd we re ra 0.40 (7%) 0.60(16%) ra 2.8% 9.6% ra 12.4% Reject project 263. Accept project 264. 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.
b.
c. d.
P9-2.
Cost of debt using both methods LG 3; Intermediate a. Net proceeds: Nd $1,010 Nd $980 $30
b.
Cash flows:
T 0 1–15 15
CF $ 980 120 1,000
c.
Cost to maturity: N 15, P 980, PMT 120, FV 1,000 Solve for I: 12.30% After-tax cost: 12.30% (1 0.4) 7.38% d. Approximate before-tax cost of debt
$120 rd
($1,000 $980) 15 ($980 $1,000) 2
rd $121.33 $990,000 rd 12.26% Approximate after-tax cost of debt e.
12.26%
(1
0.4)
7.36%
The advantages of the calculator method are evident. There are fewer
E9-1. Answer: Weighted average cost of capital N 10, PV $20,000 (1 0.02) $19,600, PMT Solve for I 8.30% 0.08 $20,000 $1,600, FV $20,000
E9-2. Cost of preferred stock Answer: The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock. rp Dp Np rp (0.15 $35) ($35 $3) rp $5.25 $32 16.4% E9-3. Cost of common stock equity Answer: The cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current price of the stock and adding the expected growth rate. rs (D1 P0) g rs ($6.50 $78) 7% 15.33% E9-4. Weighted average cost of capital (0.35 0.08) (0.65 0.13) 0.0280 (0.35 0.0845 0.106) 11.25% 0.0832 8.32% Answer: ra
E9-5. Weighted average cost of capital Answer: ra (0.55 0.067) (0.10 0.092)
Solutions to Problems
P9-1. Concept of cost of capital LG 1; Basic a. The firm is basing its decision on the cost to finance a particular project rather than the firm’s combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions. ra wd rd we re ra 0.40 (7%) 0.60(16%) ra 2.8% 9.6% ra 12.4% Reject project 263. Accept project 264. 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.
b.
c. d.
P9-2.
Cost of debt using both methods LG 3; Intermediate a. Net proceeds: Nd $1,010 Nd $980 $30
b.
Cash flows:
T 0 1–15 15
CF $ 980 120 1,000
c.
Cost to maturity: N 15, P 980, PMT 120, FV 1,000 Solve for I: 12.30% After-tax cost: 12.30% (1 0.4) 7.38% d. Approximate before-tax cost of debt
$120 rd
($1,000 $980) 15 ($980 $1,000) 2
rd $121.33 $990,000 rd 12.26% Approximate after-tax cost of debt e.
12.26%
(1
0.4)
7.36%
The advantages of the calculator method are evident. There are fewer