Essentials of Managerial Finance 14th Edition Besley Solutions Manual

Essentials of Managerial Finance 14th
Edition Besley Solutions Manual

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-finance-14th-edition-besley-solutions-manual/
CHAPTER 11
QUESTIONS
11-1 This point is demonstrated in Table 11-1 and Figures 11-2 and 11-3 in the textbook. The marginal
cost of capital is a weighted average of debt, preferred stock, and equity.
11-2 This statement is not valid, because the cost of retained earnings is equal to the cost of common
equity without considering flotation costs. If the firm cannot earn at least this rate of return on
investments funded with retained earnings, then earnings should be distributed as dividends. For a
particular firm, the cost of retained earnings is greater than the after-tax cost of debt and the cost of
preferred stock. The only higher cost of capital component is new common equity, because flotation
costs are involved.
11-3 Probable Effect on

rdT rs WACC
a. The corporate tax rate is lowered. + 0 +

b. The Federal Reserve tightens credit. + + +
c. The firm significantly increases the proportion
of debt it uses. + + +
d. The dividend payout ratio (% of earnings paid
as dividends) is increased. 0 0 0
e. The firm doubles the amount of capital it raises
during the year. 0 or + 0 or + 0 or
f. The firm expands into riskier new areas. + + +
g. The firm merges with another firm whose earnings
are countercyclical both to those of the first firm and
to the stock market. ─ ─ ─
h. The stock market falls drastically, and the value of
the firm’s stock falls along with the rest. 0 + +
i. Investors become more risk averse. + + +
j. The firm is an electric utility with a large investment in
in nuclear plants. Several states propose a ban on
nuclear power generation. + + +
11-4 Assuming that all projects are equally risky, the capital budget should be evaluated at the cost of
capital where the MCC and IOS schedules intersect. Thus, in this case, average-risk projects should
be evaluated at a 10 percent cost of capital. The cost of capital used to evaluate high-risk projects
should be adjusted upward from 10 percent, whereas for low-risk projects, a downward cost of
capital adjustment should be made.
11-5 There are three break points: (1) when the 8 percent debt is used up (at $250,000 of debt), (2) when
the 10 percent debt is used up (at $1,000,000 of debt), and when the 14 percent debt is used up (at
$5,000,000 of debt).
11-6 Inflation expectations are “built into” the market rates that investors require. As a result, if inflation
expectations increase (decrease), the cost of all type of funds will increase (decrease).
11-7 rs < re because the firm incurs flotation costs when it issues new common stock. This point can be
1
Chapter 11
seen by examining the equations for the two costs of capital:
D̂1 D̂1
rs = +g and re = +g
P0 P0 (1 − F)
11-8 If the firm invests in projects that are much riskier than its existing assets, the cost of capital will
increase because investors will demand additional compensation for the additional risk.
_____________________________________________________________
PROBLEMS
 1 
1 − (1 + YTM) 60   1 
11-1 1,353.64 = 70  + 1,000
60 
 YTM   (1 + YTM) 
 
 
Calculator solution: N = 60, PV = -1,353.64, PMT = 70, FV = 1,000; compute I = 5.1
The six-month (semiannual) rate is 5.1 percent, thus YTM = 2 x 5.1% = 10.2%, and rdT = 10.2%(1-
0.40) = 6.12%.
11-2 rdT = 12%(1 - 0.34) = 7.92%
 1 
1 − (1 + YTM)16   1 
11-3 902.81 = 30  + 1,000
16 
 YTM   (1 + YTM) 
 
 
Calculator solution: N = 16, PV = -902.81, PMT = 30, FV = 1,000; compute I = 3.82
The six-month (semiannual) rate is 3.82 percent, thus YTM = 2 x 3.82% = 7.64%
$100(0.11) $11
11-4 r ps = = = 11.94%
$97(1 − 0.05) $92.15
$15 $15
11-5 r ps = = = 12.37%
$125(1 − 0.03) $121.25
$5
11-6 rs = + 0.03 = 0.10 + 0.03 = 0.13 = 13.0%
$50
2
Chapter 11
$5.60(1.05) $5.88
11-7 rs = + 0.05 = + 0.05 = 0.084 + 0.05 = 0.134 = 13.4%
$70 $70
$5.60(1.05) $5.88
re = + 0.05 = + 0.05 = 0.09 + 0.05 = 0.14 = 14.0%
$70(1 − 0.07) $65.10
11-8 a. F = ($36.00 ─ $32.40)/$36.00 = $3.60/$36.00 = 10.0%
b. re = D̂ 1 /NP + g = $3.18/$32.40 + 6% = 9.8% + 6% = 15.8%
$3.50(1.08) $3.78
11-9 a. rs = + 0.08 = + 0.08 = 0.056 + 0.08 = 0.136 = 13.6%
$68 $68
$3.50(1.08) $3.78
b. rs = + 0.08 = + 0.08 = 0.062 + 0.08 = 0.142 = 14.2 %
$68(1 − 0.1) $61.20
 1 
1 − (1 + YTM) 60   1 
11-10 515.16 = 30  + 1,000
60 
 YTM   (1 + YTM) 
 
 
Calculator solution: N = 60, PV = -515.16, PMT = 30, and FV = 1000; compute I = 6.0. Thus YTM
= 6.0% x 2 = 12.0%, and the after-tax cost of debt is rdT = 12%(1 – 0.40) = 7.2%.
11-11 Debt = 40%, Equity = 60%, NI = $600, Retain = 40%.
P0 = $30, D0 = 2.00, D̂ 1 = 2.00(1.07) = 2.14, g = 7%, F = 25%.
RE = $600(0.4) = $240.
REBP = RE/Equity ratio = $240/0.6 = $400.
At total capital of $500, retained earnings will have been used up, so equity will come from new
common stock, whose cost will be:
$2.14
re = + 0.07 = 0.095 + 0.070 = 16.5%
$30(1 - 0.25)
$60,000
11-12 BP RE = = $80,000
0.75
3
Chapter 11
$350,000
11-13 Retained earnings break point: BP RE = = $500,000
0.70
$150,000
6.5% debt break point: BP Debt −1 = = $500,000
0.30
$450,000
7.8% debt break point: BP Debt − 2 = = $1,500,000
0.30
$840,000
9.0% debt break point: BP Debt −3 = = $2,800,000
0.30
Roberson faces three break points:

(1) $500,000, when the amount of retained earnings is exhausted and the maximum of the 6.5
percent debt is used.
(2) At the point where the maximum of the 7.8 percent is used.
(3) At the point where the maximum of the 9.0 percent is used.
11-14 Capital budget = $180,000
Debt portion of capital budget = $180,000(0.20) = $36,000
Equity portion of capital budget = $180,000(0.80) = $144,000, thus retained earnings will be
sufficient to finance the equity portion of the capital budget—that is external equity will not have to
be issued.
WACC = 5.0%(0.2) + 11.0%(0.8) = 9.8%
$240,000
11-15 Retained earnings break point: BP RE = = $400,000
0.60
$0 < capital budget < $400,000, WACC = 12%
$400,000 < capital budget, WACC = 15%
The IRRs of both Project E and Project F are greater than 15 percent (the higher WACC), so they
should be purchased. To purchase all of the projects, Mega Munchies has to invest $700,000. If the
capital budget equals $700,000, WACC = 15%. Because Project G has an IRR = 14%, it is not
acceptable.
Optimal capital budget = $500,000
11-16 rdT = 5%
rs = 10% and re = 13%

4
Chapter 11
wd = 60%, thus ws = 1- 60% = 40%
Capital budget = $700,000
debt portion of the capital budget = $700,000(0.6) = $420,000
equity portion of the capital budget = $700,000(0.4) = $280,000, which can be financed using
retained earnings
WACC = 0.6(5%) + 0.4(10%) = 7%
11-17 Capital Sources Amount Percent of Capital Structure

Long-term debt $1,152 40.0
Equity 1,728 60.0
$2,880 100.0
WACC = wdrdT + wsrs = 0.4[(13%)(1 - 0.4)] + 0.6(16%) = 3.12% + 9.60% = 12.72%.
11-18 The break points are calculated as follows:
BPRE = $3,000,000/0.5 = $6,000,000
BPDebt = $5,000,000/0.5 = $10,000,000
Now determine the weighted average cost of capital for the intervals $1– $6,000,000, $6,000,001 –
$10,000,000, and greater than $10,000,000:
Interval: $1– $6,000,000:
WACC1 = 0.5[( 8%)(0.6)] + 0.5(12%) = 8.4%
Interval: $6,000,001– $10,000,000:
WACCB = 0.5[( 8%)(0.6)] + 0.5(15%) = 9.9%.
Interval: Greater than $10,000,000:
WACCC = 0.5[(10%)(0.6)] + 0.5(15%) = 10.5%.
Finally, graph the IOS and MCC schedules.

%
11
10.5
10.2 MCC
10 9.9 IOS
9
8.4
8 Optimal Capital
5 Budget
New Capital ($ millions)

5 10 15 20
Chapter 11
Thus, the optimal capital budget is $10 million, so $10 million of the $20 million project should be
purchased.
11-19 Retained earnings are forecast to be $7,500(1 - 0.4) = $4,500. RE breakpoint = $4,500/0.6 = $7,500.
The cost of retained earnings is:
D0 (1 + g) $0.90(1.05)
rs = +g= + 0.05 = 16.0%
P0 $8.59
The cost of new equity is as follows:
$0.90(1.05)
re = + 0.05 = 18.75%
$8.59(1 - 0.20)
Now determine the weighted average costs of capital:
WACC = wdrdT + ws{rs or re}
WACC1 = 0.4[(14%)(0.6)] + 0.6(16.00%) = 12.96%.
WACC2 = 0.4[(14%)(0.6)] + 0.6(18.75%) = 14.61%.
Finally, graph the MCC and IOS schedules:
%
IRRA = 17%
17
IRRC = 16%
16
IRRD = 15%
15
14.61
MCC
IRRB = 14%
14 IOS
12.96 Optimal Capital

13 Budget = 42
10 20 30 40 50 60
New Capital ($
thousands)
Therefore, the optimal capital budget is $42,000, and projects A, C, and D are accepted.
6
Chapter 11
11-20 The firm’s marginal cost of capital is 14.61 percent. Thus, Project A (high-risk) should be evaluated
at a risk-adjusted cost of capital of 16.61 percent, while Project B (low-risk) should be evaluated at
12.61 percent. The average-risk projects (C and D) continue to be evaluated at 14.61 percent.
Now we have the following situation:
Risk-Adjusted
Project Cost of Capital IRR
A 16.61% 17%
B 12.61 14
C 14.61 16
D 14.61 15
Thus, all projects are now acceptable, and hence the optimal capital budget totals $62,000.
11-21 rd = 10%, rdT = rd(1 - T) = 10(0.6) = 6%.

Debt/Assets = 45%; D0 = $2; g = 4%; P0 = $25; NP = $20; T = 40%.
Project A: Cost = $200 million; IRR = 13%.

Project B: Cost = $125 million; IRR = 10%.
Retained earnings = $100 million.

Retained earnings break point = $100/0.55 = $181.82 million.
Cost of retained earnings = rs = $2(1.04)/$25 + 4% = 12.32%.
a. Cost of new equity = re = $2(1.04)/$20 + 4% = 14.40%.
b. WACC1 = 0.45(6%) + 0.55(12.32%) = 9.48%
WACC2 = 0.45(6%) + 0.55(14.40%) = 10.62%
FEC should use a weighted average cost of capital of 10.62% to evaluate its capital budgeting
projects because the retained earnings break point is $181.82 million and Project A has a cost
of $200 million. Project B is not acceptable.
D̂1 $2.14
11-22 a. rs = +g= + 0.07 = 0.093 + 0.07 = 0.163 = 16.3%
P0 $23
b. rs = rRF + (rM ─ rRF)βs
= 9% + (13% ─ 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.
c. rs = Bond rate + Risk premium = 12% + 4% = 16%.
d. The bond-yield-plus-risk-premium approach and the CAPM method both resulted in lower
cost of equity values than the DCF method. Because financial analysts tend to give the most
weight to the DCF method, Talukdar Technologies’ cost of equity should be estimated to be
7
Chapter 11
about 16.3 percent. If the estimates from each method are averaged, however, rs = 15.9%.
11-23 a. Solving directly, $6.50 = $4.42(1+g)5

g = ($6.50/$4.42)1/5 - 1 = 0.0802% ≈ 8%.
Alternatively, with a financial calculator, input N = 5, PV = -4.42, FV = 6.50, and then solve
for I = 8.02% ≈ 8%.
b. D̂ 1 = D0(1 + g) = $2.60(1.08) = $2.81.
c. rs = D̂ 1 /P0 + g = $2.81/$36.00 + 0.08 = 15.8%.
11-24 a. Retained earnings = ($30 million)(1 ─ Payout) = ($30 million)(0.60) = $18 million.
Retained earnings $18,000,000

b. Break point = = = $45 million
Equity as a percent of capital 0.40
c. Break point from using debt:
11% break point = $12 million/Debt percentage = $12 million/0.6 = $20 million.
12% break point = ($12 million + $12 million)/0.6 = $40 million.
D̂1
11-25 a. rs = +g
P0
$3.60
0.09 = + g = 0.06 + g
$60.00
g = 9% - 6% = 3%
b. Current EPS $5.40

Less: Dividends per share 3.60
Retained earnings per share $1.80
Rate of return x 0.09
Increase in EPS $0.162
Current EPS 5.40
Next year’s EPS $5.562
Alternatively, EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.
11-26 a. Common equity needed: 0.50($135,000,000) = $67,500,000.
b. Expected internally generated equity (retained earnings) is $13.5 million. External equity
needed is as follows:
New equity needed $67,500,000

8
Chapter 11
Retained earnings 13,500,000
External equity needed $54,000,000
c. Cost of equity:
rs = Cost of retained earnings

= Dividend yield + Growth rate = 12% = 4% + 8% = 12%.
= D̂ 1 /P0 + g = $2.40/$60 + 0.08 = 0.04 + 0.12 = 12.0%.
re = Cost of new equity

= D̂ 1 /NP + g = $2.40/$54.00 + 0.08 = 0.044 + 0.08 = 0.124 = 12.4%.
Estimated retained earnings
d. BPRE =
(Common equity/Total capital)
$13,500,000
= = $27,000,000 of total funds
0.5
e. (1) Cost below break:
After-tax Weighted
Component Weight x Cost = Cost
Debt 0.50 6.0%* 3.0%
Retained earnings 0.50 12.0% 6.0
WACC1 below break = 9.0%
*rdT = 10%(1 ─ T) = 10%(0.60) = 6%.
(2) Cost above break:

After-tax Weighted
Debt 0.50 6.0% 3.0%
New equity 0.50 12.4% 6.2
WACC2 above break = 9.2%
9
f.
The IOS curve must cut the MCC at $135 million. The slope of the IOS is not material for
this question.
11-27 a. After-tax cost of new debt: rd(1 ─ T) = 9%(1 ─ 0.4) = 5.4%.
Cost of common equity from retained earnings:
Calculate g as follows:
$7.80 = $3.90(1+g)9
g = ($7.80/$3.90)1/9 - 1 = 0.08005% = 8.0%
Alternatively, with a financial calculator, input N = 9, PV = -3.90, FV = 7.80, and then solve
for I = 8.01% = 8%.
Expected EPS2008 = $7.80(1.08) = $8.42
D̂ 1 = 0.55($8.42) = $4.63
D̂1 $4.63
rs = +g= + 0.08 = 0.071 + 0.08 = 0.151 = 15.1%
P0 $65
b. WACC1 calculation:
After-tax Weighted
Debt = [0.09(1 ─ T)] 0.40 5.4% 2.16%
Common equity (RE) 0.60 15.1% 9.06%
11.22%
wd = $104,000,000/$260,000,000 = 0.40
c. In order for the capital structure to remain optimal, retained earnings must comprise 60
10
Chapter 11
percent of total new financing before external equity is sold.
Retained earnings for 2008:
RE = (Expected EPS2009)(Number of shares)(0.45)

= ($8.42)(7.8 million shares)(0.45) = $29,554,200
Retained earnings break point = $29,554,200/0.6 = $49,257,000.
d. Cost of new equity:
From Part a, D̂ 1 = $4.63 and g = 8%. The cost of new equity is as follows:
D̂1 + g = $4.63 + 0.08 = 0.079 + 0.08 = 0.159 = 15.9%

rs =
NP $58.50
WACC2 calculation:
After-tax Weighted
Debt = [0.09(1 ─ T)] 0.40 5.4% 2.16%
New common equity 0.60 15.9% 9.54
WACC = 11.70%
11-28 a. There are three breaks in the MCC schedule. These breaks occur as follows:
Break #1 (New debt): $500,000/0.45 = $1,111,111

Break #2 (R.E.): [$2,500,000(0.4)]/0.55 = $1,818,182
Break #3 (New debt): $900,000/0.45 = $2,000,000
Break #1 is caused by exhausting the 9 percent debt, Break #2 is caused by using up retained
earnings in financing needs, and Break #3 is caused by exhausting the 11 percent debt.
b. (1) Cost below first break: Total funds of $1 to $1,111,111
After-tax Weighted
Debt = [0.09(1 ─ T)] 0.45 5.4% 2.43%
Retained earnings* 0.55 15.5% 8.53
MCC1 = 10.96% ≈ 11.0%
(2) Cost between first and second breaks: Total funds of $1,111,112 to $1,818,182
After-tax Weighted
Debt = [0.11(1 ─ T)] 0.45 6.6% 2.97%
MCC1 = 11.50% = 11.5%
11
Chapter 11
(3) Cost between second and third breaks: Total funds of $1,818,183 to $2,000,000
After-tax Weighted
Debt = [0.11(1 ─ T)] 0.45 6.6% 2.97%
MCC1 = 12.14% = 12.1%
(4) Cost above third break: Total funds greater than $2,000,000
After-tax Weighted
Debt = [0.13(1 ─ T)] 0.45 7.8% 3.51%
MCC1 = 11.68% = 12.7%
*Cost of retained earnings:
$2.20(1.05)
r s = D̂1 + g = + 0.05 = 15.5%
P0 $22
**Cost of external equity:
D̂1 + g = $2.20(1.05) + 0.05 = 16.67%

re =
P0 (1 - F) $22(0.9)
1 − 1 8 
IRR1: $675,000 = $155,401 
(1+ IRR )
c.
 IRR 
 
Financial calculator solution: Input N = 8, PV = -675,000, PMT = 155,401, and FV = 0;

compute I = IRR = 16.0%
1 − 1 3 
IRR3: $375,000 = $161,524 
(1+ IRR )
 IRR 
 
Financial calculator solution: Input N = 3, PV = -375,000, PMT = 161,524, and FV = 0;

compute I = IRR = 14.0%
12
Chapter 11
%
d. Project 1
16% Project 2
16 15% Project 3
14%
14
MCC4 = 12.7
MCC3 = 12.1
12 MCC2 = 11.5 Project 5
MCC1 = 11.0 11%
10 Project 4
12%
Optimal budget = $1,950
500 1,000 1,500 2,000 2,500 3,000 3,500

Capital Expenditure/Financing
($ thousands)
e. From the above graph, we conclude that Ezzell's management should undertake Projects 1, 2,
and 3, assuming that these projects are all about “average risk” in relation to the rest of the
firm.
f. The solution implicitly assumes (1) that all of the projects are equally risky and (2) that these
projects are as risky as the firm’s existing assets. If the accepted projects (1, 2, and 3) were of
above average risk, this would raise the company’s overall risk, hence its cost of capital.
Possibly, taking on these projects would result in a decline in the company’s value.
g. If the payout ratio were lowered to zero, this would shift the equity break point to the right,
from $1,818,182, to $4,545,455. This shift would have changed the decision—Project 4
would now be acceptable and the capital budget would have increased from $1,950,000 under
the original assumptions to $2,512,500. (Note that at $2,000,000 the 11 percent debt has been
exhausted; thus MCC3 = 12.1%; however, the average marginal cost of Project 4 is 11.99%.
Because 11.99% < 12.1%, the project is acceptable—although barely.) If the payout ratio
were raised to 100 percent, the equity break point would shift to zero; however, this shift
would not change the original decision. Note, however, that these reconstructions assume r s
and re are unaffected by the payout ratio. In reality, rs and re might be affected, so a change in
the payout ratio might actually raise their values, hence increase MCC.
13
Chapter 11
INTEGRATIVE PROBLEM
11-29 ASSUME THAT YOU WERE RECENTLY HIRED AS ASSISTANT TO JERRY

LEHMAN, FINANCIAL VP OF COLEMAN TECHNOLOGIES. YOUR FIRST TASK
IS TO ESTIMATE COLEMAN’S COST OF CAPITAL. LEHMAN HAS PROVIDED
YOU WITH THE FOLLOWING DATA, WHICH HE BELIEVES MAY BE
RELEVANT TO YOUR TASK:
(1) THE FIRM’S MARGINAL TAX RATE IS 40 PERCENT.
(2) THE CURRENT PRICE OF COLEMAN’S 12 PERCENT COUPON,
SEMIANNUAL PAYMENT, NONCALLABLE BONDS WITH 15 YEARS
REMAINING TO MATURITY IS $1,153.72. COLEMAN DOES NOT USE
SHORT-TERM INTEREST-BEARING DEBT ON A PERMANENT BASIS. NEW
BONDS WOULD BE PRIVATELY PLACED WITH NO FLOTATION COST.
(3) THE CURRENT PRICE OF THE FIRM’S 10 PERCENT, $100 PAR VALUE,
QUARTERLY DIVIDEND, PERPETUAL PREFERRED STOCK IS $113.10.
COLEMAN WOULD INCUR FLOTATION COSTS OF $2.00 PER SHARE ON A
NEW ISSUE.
(4) COLEMAN’S COMMON STOCK IS CURRENTLY SELLING AT $50 PER
SHARE. ITS LAST DIVIDEND (D 0) WAS $4.19, AND DIVIDENDS ARE
EXPECTED TO GROW AT A CONSTANT RATE OF 5 PERCENT IN THE
FORESEEABLE FUTURE. COLEMAN’S BETA IS 1.2, THE YIELD ON
TREASURY BONDS IS 7 PERCENT, AND THE MARKET RISK PREMIUM IS
ESTIMATED TO BE 6 PERCENT. FOR THE BOND-YIELD-PLUS-RISK-
PREMIUM APPROACH, THE FIRM USES A 4 PERCENTAGE POINT RISK
PREMIUM.
(5) UP TO $300,000 OF NEW COMMON STOCK CAN BE SOLD AT A
FLOTATION COST OF 15 PERCENT. ABOVE $300,000, THE FLOTATION
COST WOULD RISE TO 25 PERCENT.
(6) COLEMAN’S TARGET CAPITAL STRUCTURE IS 30 PERCENT LONG-
TERM DEBT, 10 PERCENT PREFERRED STOCK, AND 60 PERCENT
COMMON EQUITY.
(7) THE FIRM IS FORECASTING RETAINED EARNINGS OF $300,000 FOR THE
COMING YEAR.
TO STRUCTURE THE TASK SOMEWHAT, LEHMAN HAS ASKED YOU TO
ANSWER THE FOLLOWING QUESTIONS.
A. (1) WHAT SOURCES OF CAPITAL SHOULD BE INCLUDED WHEN YOU

ESTIMATE COLEMAN’S WEIGHTED AVERAGE COST OF CAPITAL
(WACC)?
14
Chapter 11
ANSWER: The WACC is used primarily for making long-term capital investment decisions—that is, for
capital budgeting. Thus, the WACC should include the types of capital used to pay for long-term assets, and
this typically is long-term debt, preferred stock (if used), and common stock. Short-term sources of capital
consist of (1) spontaneous, noninterest-bearing liabilities such as accounts payable and accruals and (2)
short-term interest-bearing debt, such as notes payable. If the firm uses short-term interest-bearing debt to
acquire fixed assets rather than just to finance working capital needs, then the WACC should include a
short-term debt component. Noninterest-bearing debt generally is not included in the cost of capital estimate
because these funds are netted out when determining investment needs, that is, net rather than gross working
capital is included in capital expenditures.
A. (2) SHOULD THE COMPONENT COSTS BE FIGURED ON A BEFORE-TAX OR

AN AFTER-TAX BASIS? EXPLAIN.
ANSWER: Stockholders are concerned primarily with those corporate cash flows that are available for their
use, namely, those cash flows available to pay dividends or for reinvestment. Because dividends are paid from
and reinvestment is made with after-tax dollars, all cash flow and rate of return calculations should be done on
an after-tax basis.
A. (3) SHOULD THE COSTS BE HISTORICAL (EMBEDDED) COSTS OR NEW

(MARGINAL) COSTS? EXPLAIN.
ANSWER: In financial management, the cost of capital is used primarily to make decisions that involve
raising new capital. Thus, the relevant component costs are today's marginal costs rather than historical costs.
B. WHAT IS THE MARKET INTEREST RATE ON COLEMAN’S DEBT AND ITS

COMPONENT COST OF DEBT?
ANSWER: Coleman’s 12 percent bond with 15 years to maturity currently is selling for $1,153.72. Thus, its
yield to maturity is 10 percent:
0 1 2 3 29 30
rd = …
?
-1,153.70 60 60 60 60 60
1,000
Enter N = 30, PV = 1,153.72, PMT = 60, and FV = 1,000, and then compute r d/2 = I = 5.0%.
Because this a semiannual rate, multiply by 2 to find the annual rate, r d = 10%, which is the pre-tax cost of
debt.
The approximate YTM can be computed as follows:
$60 +  $1,000 -30

$1,153.72 

 
r d/2  = 0.0498  5%.
 2($1,153.72) + $1,000 
 
 3 
15
Chapter 11
Because interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and Coleman’s relevant
component cost of debt is the after-tax cost:
rd(1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%.
*************************************************************************
OPTIONAL QUESTION: SHOULD FLOTATION COSTS BE INCLUDED IN THE ESTIMATE?
ANSWER: The actual component cost of new debt will be somewhat higher than 6 percent because the firm
will incur flotation costs in selling the new issue. However, flotation costs typically are small on public debt
issues, and, more important, much debt is placed directly with banks, insurance companies, and the like, and
in this case flotation costs are almost nonexistent.
OPTIONAL QUESTION: SHOULD YOU USE THE SIMPLE COST OF DEBT OR THE EFFECTIVE
ANNUAL COST?
ANSWER: Our 10 percent pre-tax estimate is the simple cost of debt. Because the firm’s debt has semiannual
coupons, its effective annual rate is 10.25 percent:
EAR = (1.05)2 - 1.0 = 1.1025 - 1.0 = 0.1025 = 10.25%.
However, simple rates generally are used. The reason is that the cost of capital is used in capital budgeting,
and capital budgeting cash flows generally are assumed to occur at year-end. Therefore, using simple rates
makes the treatment of the capital budgeting discount rate and cash flows consistent.
************************************************************************
C. (1) WHAT IS THE FIRM’S COST OF PREFERRED STOCK?
ANSWER: Because the preferred issue is perpetual, its cost is estimated as follows:
Dps 0.1($100)
rps = = = 0.09 = 9.0%
NP $113.10 - $2.00
Note that (1) flotation costs for preferred are significant, so they are included here, (2) because preferred
dividends are not deductible to the issuer, there is no need for a tax adjustment, and (3) we could have
estimated the effective annual cost of the preferred, but as in the case of debt, the simple cost is generally
used.
C. (2) COLEMAN’S PREFERRED STOCK IS RISKIER TO INVESTORS THAN ITS

DEBT, YET THE YIELD TO INVESTORS IS LOWER THAN THE YIELD TO
MATURITY ON THE DEBT. DOES THIS SUGGEST THAT YOU HAVE MADE A
MISTAKE? (HINT: THINK ABOUT TAXES.)
ANSWER: Corporate investors own most preferred stock, because 70 percent of preferred dividends received
by corporations are nontaxable. Therefore, preferred often has a lower before-tax yield than the before-tax
yield on debt issued by the same company. Note, though, that the after-tax yield to a corporate investor, and
the after-tax cost to the issuer, are higher on preferred stock than on debt.
16
D. (1) WHY IS THERE A COST ASSOCIATED WITH RETAINED EARNINGS?
ANSWER: Coleman’s earnings can either be retained and reinvested in the business or paid out as dividends.
If earnings are retained, Coleman’s shareholders forego the opportunity to receive cash and to reinvest it in
stocks, bonds, real estate, and the like. Thus, Coleman should earn on its retained earnings at least as much as
its stockholders themselves could earn on alternative investments of equivalent risk. Further, the company’s
stockholders could invest in Coleman’s own common stock, where they could expect to earn r s. We conclude
that retained earnings have an opportunity cost that is equal to rs, the rate of return investors expect on the
firm’s common stock.
D. (2) WHAT IS COLEMAN’S ESTIMATED COST OF RETAINED EARNINGS USING

THE CAPM APPROACH?
ANSWER: The CAPM estimate for Coleman’s cost of retained earnings is 14.2 percent:
rs = rRF + (rM - rRF)ßs = 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%.
E. WHAT IS THE ESTIMATED COST OF RETAINED EARNINGS USING THE

DISCOUNTED CASH FLOW (DCF) APPROACH?
ANSWER: Because Coleman is a constant growth stock, the constant growth model can be used:
D̂1 D (1 + g )
rs = r̂s = +g= 0 +g
P0 P0
$4.19(1.05) $4.40
= + 0.05 = + 0.05 = 0.138 = 13.8%
$50 $50
F. WHAT IS THE BOND-YIELD-PLUS-RISK-PREMIUM ESTIMATE FOR COLEMAN’S

COST OF RETAINED EARNINGS?
ANSWER: The bond-yield-plus-risk-premium estimate is 14 percent:
rs = Bond yield + Risk premium = rd + RP
= 10.0% + 4.0% = 14.0%.
Note that the risk premium required in this method is difficult to estimate, so this approach only provides a
ballpark estimate of rs. It is useful, though, as a check on the DCF and CAPM estimates, which can, under
certain circumstances, produce unreasonable estimates.
G. WHAT IS YOUR FINAL ESTIMATE FOR rs?
17
Chapter 11
ANSWER: The following table summarizes the rs estimates:
Method Estimate
CAPM 14.2%
DCF 13.8
rd + RP 14.0
Average 14.0%
At this point, considerable judgment is required. If a method is deemed to be inferior due to the “quality” of
its inputs, then it might be given little weight or even disregarded. In our example, though, the three methods
produced relatively close results, so we decided to use the average, 14 percent, as our estimate for Coleman’s
cost of retained earnings.
H. WHAT IS COLEMAN'S COST FOR UP TO $300,000 OF NEWLY ISSUED COMMON

STOCK, re1? WHAT HAPPENS TO THE COST OF EQUITY IF COLEMAN SELLS
MORE THAN $300,000 OF NEW COMMON STOCK?
ANSWER: The DCF method produced an estimate for the cost of retained earnings of r s = 13.8% (see the
computations given earlier). However, flotation costs of F = 15% must be incurred when new common stock
is sold, and that increases the cost of equity to 15.4%:
D0 (1 + g)
re = +g
P0 (1 - F)
$4.19(1.05) $4.40
= + 0.05 = + 0.05 = 0.104 + 0.05 = 0.154 = 15.4%
$50(1 - 0.15) $42.50
Thus, flotation costs increase the cost of equity by 1.6 percentage points for up to $300,000 of new common
stock:
Flotation adjustment1 = 15.4% - 13.8% = 1.6%.
We can add the 1.6% flotation adjustment to the average of the three common equity costs, r s = 14%, to find
re1 for up to $300,000 of new stock:
re1 = rs + Flotation adjustment1 = 14% + 1.6% = 15.6% for up to $300,000 of new stock.
If Coleman sells more than $300,000 of new common stock, then this additional stock will involve a flotation
cost of 25 percent. That, in turn, will lead to a still higher cost of equity. We can substitute F = 0.25 for 0.15
in the formula above to obtain a cost re2 = $4.40/$37.50 + 0.05 = 16.7%. Thus, the flotation adjustment for
more than $300,000 of stock is:
Flotation adjustment2 = 16.7% - 13.8% = 2.9%.
Therefore, the cost of new common stock in excess of $300,000 will be
re2 = 14.0% + 2.9% = 16.9%.
18
Chapter 11
I. EXPLAIN IN WORDS WHY NEW COMMON STOCK HAS A HIGHER

PERCENTAGE COST THAN RETAINED EARNINGS.
ANSWER: The company is raising money in order to make an investment. The money has a cost, and this
cost is based primarily on the investors’ required rate of return, considering risk and alternative investment
opportunities. So, the new investment must provide a return at least equal to the investors’ opportunity cost.
If the company raises capital by selling stock, the company doesn’t get all of the money that investors put up.
For example, if investors put up $100,000, and if they expect a 15 percent return on that $100,000, then
$15,000 of profits must be generated. But if flotation costs are 20 percent ($20,000), then the company will
receive only $80,000 of the $100,000 investors put up. That $80,000 must then produce a $15,000 profit, or a
15/80 = 18.75% rate of return versus a 15 percent return on equity raised as retained earnings.
J. (1) WHAT IS COLEMAN’S OVERALL, OR WEIGHTED AVERAGE, COST OF

CAPITAL (WACC) WHEN RETAINED EARNINGS ARE USED AS THE
EQUITY COMPONENT?
ANSWER: Coleman’s WACC is 11.1 percent when retained earnings are used as the equity component (at
14 percent):
Up to $300,000 of equity as RE at rs = 14%:
Capital Structure Component

Weights x costs = WACC
0.3 6.0% 1.8%
0.1 9.0 0.9
0.6 14.0 8.4
1.0 WACC1 = 11.1%
WACC1 = wdrdT + wpsrps + wsrs

= 0.3(6%) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%
Note: Point out to students that we are concerned here with retained earnings for the year in question (net
income - dividends paid), not the accumulated historical retained earnings as shown on the balance sheet. The
retained earnings shown on the balance sheet were invested in assets in the past.
J. (2) WHAT IS THE WACC AFTER RETAINED EARNINGS HAVE BEEN

EXHAUSTED AND COLEMAN USES UP TO $300,000 OF NEW COMMON
STOCK WITH A 15 PERCENT FLOTATION COST?
ANSWER: When up to $300,000 of new common stock is sold, the WACC increases from 11.1 percent to
WACC2 = 12.1 percent:
Capital Structure Component

Weights x costs = WACC
0.3 6.0% 1.8%
19
Chapter 11
0.1 9.0 0.9
0.6 15.6 9.4
1.0 WACC1 = 12.1%
WACC2 = 0.3(6%) + 0.1(9%) + 0.6(15.6%) = 1.8% + 0.9% + 9.4% = 12.1%.
J. (3) WHAT IS THE WACC IF MORE THAN $300,000 OF NEW COMMON EQUITY
IS SOLD?
ANSWER: When more than $300,000 of new common stock is sold, the WACC increases to 12.8 percent:
WACC3 = 0.3(6%) + 0.1(9%) + 0.6(16.9%) = 1.8% + 0.9% + 10.1% = 12.8%.
K. (1) AT WHAT AMOUNT OF NEW INVESTMENT WOULD COLEMAN BE

FORCED TO ISSUE NEW COMMON STOCK? TO PUT IT ANOTHER WAY,
WHAT IS THE LARGEST CAPITAL BUDGET THE COMPANY COULD
SUPPORT WITHOUT ISSUING NEW COMMON STOCK? ASSUME THAT
THE 30/10/60 TARGET CAPITAL STRUCTURE WILL BE MAINTAINED.
ANSWER: The dollar amount of total new capital at which Coleman uses up its retained earnings and must
resort to selling new common stock will consist of the retained earnings plus debt and preferred supported by
the retained earnings, and the point is called the retained earnings break point:
D ollars of retained earnings $300,000

BPRE = = = $500,000
Target proportion of equity 0.60
In raising $500,000 of new capital, Coleman would finance as follows:
Debt: 0.3($500,000) = $150,000

Preferred: 0.1($500,000) = 50,000
Retained earnings: 0.6($500,000) = 300,000
Total: $500,000
If the firm required an additional $1 of new capital over the $500,000, this marginal $1 would be raised by
selling $0.30 of debt, $0.10 of preferred, and $0.60 of new common stock, because all of the retained earnings
would have already been used up. Note that, in reality, the firm might finance using debt in one year,
preferred the next, and equity in the third, but, over the long haul, Coleman would finance in accordance with
its target capital structure, so the target weights should be used regardless of the actual financing in any one
year.
K. (2) AT WHAT AMOUNT OF NEW INVESTMENT WOULD COLEMAN BE

FORCED TO ISSUE NEW COMMON STOCK WITH A 25 PERCENT
FLOTATION COST?
B reak = T otal amount of lower cost capital of a given type

P o int P roportion of this type of capital in the capital strucure
20
Chapter 11
Now we apply the formula, using $300,000 of retained earnings + $300,000 of low cost common in the
numerator:
$300,000 + $300,000
BP = = $1,000,000
0.60
Debt: 0.3($1,000,000) = $ 300,000

Preferred: 0.1($1,000,000) = 100,000
Common: 0.6($1,000,000) = 600,000 ($300,000 of RE + $300,000 New stock)
Total $ 1,000,000
K. (3) WHAT IS A MARGINAL COST OF CAPITAL (MCC) SCHEDULE?

CONSTRUCT A GRAPH THAT SHOWS COLEMAN’S MCC SCHEDULE.
ANSWER: A marginal cost of capital (MCC) schedule is simply a plot of the firm’s WACC versus dollars of
new capital raised. Here is Coleman’s MCC schedule:
Percent
20
15
WACC3 = 12.8%
WACC2 = 12.1% MCC
WACC2 = 11.1%
10
1,500 New Capital

500 1,000 2,000
($ thousands)
The plot is called the marginal cost of capital (MCC) schedule because it shows the cost of each additional, or
marginal, dollar raised (the marginal cost).
21
Chapter 11
L. COLEMAN’S DIRECTOR OF CAPITAL BUDGETING HAS IDENTIFIED THE

FOLLOWING POTENTIAL PROJECTS:
PROJECT COST LIFE CASH FLOW IRR

A $700,000 5 YEARS $218,795 17.0%
B 500,000 5 152,705 16.0
B* 500,000 20 79,881 15.0
C 800,000 5 219,185 11.5
PROJECTS B AND B* ARE MUTUALLY EXCLUSIVE, WHEREAS THE OTHER

PROJECTS ARE INDEPENDENT. ALL OF THE PROJECTS ARE EQUALLY RISKY.
(1) PLOT THE IOS SCHEDULE ON THE SAME GRAPH THAT CONTAINS YOUR
MCC SCHEDULE. WHAT IS THE FIRM’S MARGINAL COST OF CAPITAL
FOR CAPITAL BUDGETING PURPOSES?
ANSWER: the IOS schedule is a plot of the projects being considered by cost and in descending order of
IRR. Note that Coleman actually faces two IOS schedules—one with Projects A, B, and C, and another with
Projects A, B*, and C.
Percent
20
A = 17%
B = 16%
B’ = 15%
15
WACC3 = 12.8%
WACC2 = 12.1% MCC
C = 11.5%
WACC2 = 11.1% IOS
Optimal Capital
10
Budget
500 1,000 1,200 1,500 2,000 New Capital

($ Thousands)
A firm’s marginal cost of capital is defined by the intersection of the IOS and MCC schedules. Therefore,
Coleman’s MCC is 12.8 percent.
L. (2) WHAT IS THE DOLLAR SIZE, AND THE INCLUDED PROJECTS, IN

COLEMAN'S OPTIMAL CAPITAL BUDGET? EXPLAIN YOUR ANSWER
FULLY.
ANSWER: If a project has average risk, then its cost of capital is the firm’s MCC. Thus, assuming average
risk, all projects should be discounted at the firm’s 12.8 percent MCC. Because the IRR and NPV rules lead
22
Chapter 11
to the same accept/reject decisions for independent projects, all independent projects with IRRs above 12.8
percent should be accepted. Thus, Project A is acceptable but Project C is not.
However, conflicts can arise between NPV and IRR when evaluating mutually exclusive projects, and
mutually exclusive projects should be evaluated using the NPV rule. Therefore, Coleman should choose
between Projects B and B* on the basis of which one has the higher NPV when discounted at a 12.8 percent
cost of capital. Using a financial calculator, we find NPVB = $39,730 and NPVB* = $67,959. If we assume that
Project B cannot be repeated then Project B* should be selected, and the capital budget should consist of
Projects A and B*, for a total of $1,200,000.
L. (3) WOULD COLEMAN’S MCC SCHEDULE REMAIN CONSTANT AT 12.8

PERCENT BEYOND $2 MILLION REGARDLESS OF THE AMOUNT OF
CAPITAL REQUIRED?
ANSWER: As more and more new capital is required in any year, Coleman’s WACC would eventually begin
to rise above 12.8 percent. The company would have to find new buyers for its debt, preferred, and common
stock, and those new buyers would require higher rates of return to be enticed to invest in Coleman’s
securities. Also, particularly large capital investment programs probably would increase Coleman’s perceived
riskiness, because investors would become increasingly concerned about management’s ability to manage
such rapid growth efficiently. (Note: Most firms do not attempt to quantify the MCC precisely early in the
planning process. But if they contemplate that extraordinarily large amounts of capital will have to be raised,
they do adjust the WACC upward.)
L. (4) IF WACC3 HAD BEEN 18.5 PERCENT RATHER THAN 12.8 PERCENT, BUT
THE SECOND WACC BREAK POINT HAD STILL OCCURRED AT
$1,000,000, HOW WOULD THAT HAVE AFFECTED THE ANALYSIS?
ANSWER: In this situation, the MCC curve would cut through Projects B and B*, meaning that those
projects, if taken on, would be financed partly with 12.1 percent capital and partly with 18.5 percent capital:
Average cost = (0.6)(12.1%) + (0.4)(18.5%) = 14.66%. Using this value, we would find NPV B = $16,039 and
NPVB* = $9,567. Therefore, in this situation we would choose B over B*. (If we drew NPV profiles for B and
B*, we would find that B* has the steeper slope, and the crossover point is 14.27 percent. To the left of 14.27
percent, NPVB* > NPVB, but the reverse holds to the right of 14.27 percent.)
M. SUPPOSE YOU LEARNED THAT COLEMAN COULD RAISE ONLY $200,000 OF

NEW DEBT AT A 10 PERCENT INTEREST RATE AND THAT NEW DEBT
BEYOND $200,000 WOULD HAVE A YIELD TO INVESTORS OF 12 PERCENT.
TRACE BACK THROUGH YOUR WORK AND EXPLAIN HOW THIS NEW FACT
WOULD CHANGE THE SITUATION.
ANSWER: If Coleman could only raise $200,000 of debt at a 10 percent cost and the remaining debt would
cost 12 percent this would cause an additional break point to the MCC schedule. This debt break point would
be calculated as $200,000/0.3 = $666,667. Thus, break points would now occur at $500,000, $666,667, and
$1,000,000. The after-tax cost of this debt would be 12%(1 ─ 0.4) = 7.2%.
The WACCs at these intervals would be:
23
Chapter 11
A. Between $0 and $500,000: WACC1 = 11.1%. (just as before.)
B. Between $500,000 and $666,667: WACC2 = 12.1%. (just as before.)
C. Between $666,667 and $1,000,000: WACC3 = 0.3(7.2%) + 0.1(9%) + 0.6(15.6%) = 12.4%.

(This break is due to the higher cost of debt after $200,000 of debt has been raised.)
D. Greater than $1,000,000: WACC4 = 0.3(7.2%) + 0.1(9%) + 0.6(16.9%) = 13.2%.

(This break point is the same as before, but WACC 4 has increased from the previous WACC3 = 12.8%
also due to the new cost of debt.)
Even though the MCC schedule’s appearance includes an additional break, it does not change the decision of
which projects to accept or the amount of the optimal capital budget.
24
Chapter 11
11-30 Computer-Related Problem
a. Under this scenario, the MCC schedule has moved down because all of
the WACCs have decreased. Projects 1, 2, and 3 are still acceptable;
however, Project 4 becomes acceptable. The capital budget is now
$2,512,500.
INPUT DATA: KEY OUTPUT:

Debt ratio: 65.00% Ret. earnings break $2,857,143
Earnings: $2,500,000.00 1st debt break $ 769,231
Dividend payout: 60.00% 2nd debt break $1,384,615
Tax rate: 40.00%
Current Stock Price: $22.00 WACC before break 1 9.7%
Previous dividend (D0): $2.20 WACC before break 2 10.5%
Growth rate: 6.00% WACC before break 3 11.3%
Equity flotation cost: 10.00% WACC after break 3 11.7%
Accepted
Beginning of Projects Project
New debt cost: Range r(d) (non-zero) ROR Cost
$ 0 10.00% 1 16% $ 675,000
$500,001 12.00% 2 15% 900,000
$900,001 14.00% 3 14% 375,000
4 12% 562,500
Project Cost ROR 0 0% 0
__________
Number/rank
1 $675,000 16.00% Capital budget = $2,512,500
2 900,000 15.00%
3 375,000 14.00%
4 562,500 12.00%
5 750,000 11.00%
MODEL-GENERATED DATA:
Breaks in the MCC schedule:
Use of retained earnings $2,857,143

Use of debt at: 10% $ 769,231
Use of debt at: 12% $1,384,615
Cost of financing below first break:
After-tax Weighted
Component Weight Cost Cost
_________ ______ _________ ________
Debt 0.65 6.00% 3.90%
Equity 0.35 16.60% 5.81%
WACC 1 = 9.71%
Cost of financing between first and second breaks:
After-tax Weighted
_________ ______ _________ ________
Debt 0.65 7.20% 4.68%
Equity 0.35 16.60% 5.81%
WACC 2 = 10.49%
25
Chapter 11
Cost of financing between second and third breaks:
After-tax Weighted
_________ ______ _________ ________
Debt 0.65 8.40% 5.46%
Equity 0.35 16.60% 5.81%
WACC 3 = 11.27%
Cost of financing above third break:

After-tax Weighted
_________ ______ _________ ________
Debt 0.65 8.40% 5.46%
Equity 0.35 17.78% 6.22%
WACC 4 = 11.68%
Capital Cost:
Range of financing Capital cost

__________________ ____________
$ 0 9.7%
769,231 9.7%
769,232 10.5%
1,384,615 10.5%
1,384,616 11.3%
2,857,143 11.3%
2,857,144 11.7%
5,000,000 11.7%
Optimal capital budget:
Project Project
Number/rank ROR Cost
___________ ___ __________
1 16% $ 675,000
2 15% 900,000
3 14% 375,000
4 12% 562,500
0 0% 0
$2,512,500
b. At a tax rate of 20 percent, the MCC curve shifts up, so only Projects
1, 2, and 3 remain acceptable. If the tax rate falls to 0 percent,
only Projects 1 and 2 would be acceptable.
TAX RATE = 20 PERCENT:

Dividend payout: 60.00% 2nd debt break $1,384,615
Tax rate: 20.00%
26
Chapter 11
Accepted
____________ ______ __________ ___ __________
$ 0 10.00% 1 16% $ 675,000
$500,001 12.00% 2 15% 900,000
$900,001 14.00% 3 14% 375,000
0 0% 0
0 0% 0
Capital budget = $1,950,000
TAX RATE = 0 PERCENT:

Debt ratio: 65.00% Ret. earnings break
$2,857,143
Dividend payout: 60.00% 2nd debt break
$1,384,615
Tax rate: 0.00%
Accepted
____________ ______ __________ ___ __________
$ 0 10.00% 1 16% $ 675,000
$500,001 12.00% 2 15% 900,000
$900,001 14.00% 0 0% 0
0 0% 0
0 0% 0
c. If earnings are as high as $3.25 million or as low as $1,000,000

Projects 1, 2, 3, and 4 are still acceptable. Project 5 is still
not acceptable in either situation.
EARNINGS = $3.25 million:

$1,384,615
Tax rate: 40.00%
Accepted
27
Chapter 11
____________ ______ __________ ___ __________
$ 0 10.00% 1 16% $ 675,000
$500,001 12.00% 2 15% 900,000
$900,001 14.00% 3 14% 375,000
4 12% 562,500
0 0% 0
EARNINGS = $1 million:

Debt ratio: 65.00% Ret. earnings break
$1,142,857
$1,384,615
Tax rate: 40.00%
Accepted
____________ ______ __________ ___ __________
$ 0 10.00% 1 16% $ 675,000
$500,001 12.00% 2 15% 900,000
$900,001 14.00% 3 14% 375,000
4 12% 562,500
0 0% 0
d. No. A change in the payout ratio would certainly affect g, hence the
cost of equity. This point is explained in more detail in Chapter 11.
28
Chapter 11
ETHICAL DILEMMA
HOW MUCH SHOULD YOU PAY TO BE “GREEN”?
Ethical dilemma:
SS is evaluating a project that might help the firm to increase its presence in the “green”
industry by propelling the company into the leadership role in the country’s quest to clean up and
protect the environment. Although Tracey is not evaluating the project’s acceptability, it is her
responsibility to establish the hurdle rate, or weighted average cost of capital (WACC), that is
used by those who conduct capital budgeting analyses. Tracey, who is a compassionate
environmentalist, would like to see SS invest in the project. But, Manual, who works in the
capital budgeting department, has told Tracey that preliminary analysis of the project suggests
that its internal rate of return (IRR) is less than the firm’s WACC, which would mean that the
project is not an acceptable investment. Because Tracey feels the company should purchase the
project, she is considering changing the method that she currently uses to compute the firm’s
WACC. If she makes the change, the hurdle rate used to evaluate the “green” project will be
lower than it is currently, and thus the project might turn out to be acceptable. However, if SS
bases its decision on a hurdle rate that is too low and invests a substantial amount in the project,
in the future it might discover that the project actually should have been rejected. It is possible
that this discovery comes too late for the firm to correct its mistake, in which case the firm might
find itself in serious financial trouble.
Discussion questions:
■ Is there an ethical problem? If so, what is it?
The question here is whether Tracey should change the weights that she currently uses to
compute SS’s WACC. Should Tracey change the way she computes the firm’s WACC just
because she wants SS to invest in the “green” project? Would it be appropriate for Tracey to
change the computation if she believes that it is more appropriate to use book values than
market values to determine the weights for the component costs of capital? Is Tracey
considering performing an unethical act in support of a cause for which she has a tremendous
compassion? Perhaps.
■ Is it appropriate for Tracey to change the hurdle rate used to evaluate capital budgeting
projects?
Maybe. If Tracey can justify using book values rather than market values to weight the
component costs of capital, then it seems that she is making a rational, justifiable change. In
fact, the change should be made in this case. But, if Tracey is changing the computation
solely because she wants to improve the chances of the “green” project being accepted, then
she is jeopardizing her career. Tracey does not have much information about the project. She
has heard rumors that the project’s IRR is less than the firm’s current WACC, and she
believes that changing the method used to compute the firm’s WACC will lower this hurdle
29
Chapter 11
rate such that the project will be acceptable. In reality, it is possible that neither of these
suppositions is correct. Tracey really doesn’t know whether the project is acceptable if she
continues to compute the firm’s WACC as it has been in the past; in reality, the project might
be acceptable when the capital budgeting analysis is complete. Further, even if the rumors
are true, Tracey can’t be sure that if she changes the method used to compute the WACC the
project will be acceptable.
■ What would you do if you were Tracey?
Perhaps the best solution is to compute the firm’s WACC using both book values and market
values to determine the weights for component costs of capital. Before changing the methods
that the firm currently uses for the WACC computation, Tracey should get approval. If she
can show that using book values in the WACC computation is more appropriate than using
market values, the firm should revise the manner in which the hurdle rate is computed. Firms
should not use particular techniques to provide input to important decisions, such as that
which is needed to make capital budgeting decisions, just because the methods make the
firms look good or prove advantageous for particular decisions that executives favor. Firms
should use methods that help make correct decisions.
Another factor that Tracey should consider is the risk of the project. Information about the
project’s riskiness is not provided in the Ethical Dilemma. However, risk needs to be
considered. As discussed in the book, projects that have greater risk than average should be
evaluated with higher hurdle rates, and vice versa. As a result, if the “green” project is less
risky than the firm’s average investment, the capital budgeting department should use a
hurdle rate that is lower than the WACC used to evaluate average-risk projects. In this case,
the project might turn out to be acceptable.
References:
The following articles might be assigned for background material:
Pete Engardio, “Beyond the Green Corporation,” BusinessWeek, January 29, 2007, pp. 50-
64.
John Carey, “Hugging the Tree-Huggers—Why So Many Companies are Suddenly Linking
Up with ECO Groups. Hint: Smart Business,” BusinessWeek, March 12, 2007, pp. 66-68.
Ian Ayes and Barry Nalebuff, “Environmental Atonement: Why Not,” Forbes, December 25,
2006, p. 134.
Emily Thornton, “Who Says It’s Not Easy Being Green,” BusinessWeek, December 25,
2006, p. 76.
30

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Essentials of Managerial Finance 14th

Edition Besley Solutions Manual

11-3 Probable Effect on

a. The corporate tax rate is lowered. + 0 +

11-2 rdT = 12%(1 - 0.34) = 7.92%

Calculator solution: N = 16, PV = -902.81, PMT = 30, FV = 1,000; compute I = 3.82

11-8 a. F = ($36.00 ─ $32.40)/$36.00 = $3.60/$36.00 = 10.0%

b. re = D̂ 1 /NP + g = $3.18/$32.40 + 6% = 9.8% + 6% = 15.8%

11-11 Debt = 40%, Equity = 60%, NI = $600, Retain = 40%.

P0 = $30, D0 = 2.00, D̂ 1 = 2.00(1.07) = 2.14, g = 7%, F = 25%.

REBP = RE/Equity ratio = $240/0.6 = $400.

Roberson faces three break points:

11-14 Capital budget = $180,000

Debt portion of capital budget = $180,000(0.20) = $36,000

WACC = 5.0%(0.2) + 11.0%(0.8) = 9.8%

$0 < capital budget < $400,000, WACC = 12%

$400,000 < capital budget, WACC = 15%

Optimal capital budget = $500,000

rs = 10% and re = 13%

wd = 60%, thus ws = 1- 60% = 40%

Capital budget = $700,000

debt portion of the capital budget = $700,000(0.6) = $420,000

WACC = 0.6(5%) + 0.4(10%) = 7%

11-17 Capital Sources Amount Percent of Capital Structure

WACC = wdrdT + wsrs = 0.4[(13%)(1 - 0.4)] + 0.6(16%) = 3.12% + 9.60% = 12.72%.

11-18 The break points are calculated as follows:

BPRE = $3,000,000/0.5 = $6,000,000

BPDebt = $5,000,000/0.5 = $10,000,000

Interval: $1– $6,000,000:

WACC1 = 0.5[( 8%)(0.6)] + 0.5(12%) = 8.4%

Interval: $6,000,001– $10,000,000:

WACCB = 0.5[( 8%)(0.6)] + 0.5(15%) = 9.9%.

Interval: Greater than $10,000,000:

WACCC = 0.5[(10%)(0.6)] + 0.5(15%) = 10.5%.

Finally, graph the IOS and MCC schedules.

New Capital ($ millions)

Now determine the weighted average costs of capital:

WACC = wdrdT + ws{rs or re}

WACC1 = 0.4[(14%)(0.6)] + 0.6(16.00%) = 12.96%.

WACC2 = 0.4[(14%)(0.6)] + 0.6(18.75%) = 14.61%.

Finally, graph the MCC and IOS schedules:

12.96 Optimal Capital

Now we have the following situation:

11-21 rd = 10%, rdT = rd(1 - T) = 10(0.6) = 6%.

Project A: Cost = $200 million; IRR = 13%.

Retained earnings = $100 million.

Cost of retained earnings = rs = $2(1.04)/$25 + 4% = 12.32%.

a. Cost of new equity = re = $2(1.04)/$20 + 4% = 14.40%.

b. WACC1 = 0.45(6%) + 0.55(12.32%) = 9.48%

WACC2 = 0.45(6%) + 0.55(14.40%) = 10.62%

b. rs = rRF + (rM ─ rRF)βs

= 9% + (13% ─ 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

11-23 a. Solving directly, $6.50 = $4.42(1+g)5

b. D̂ 1 = D0(1 + g) = $2.60(1.08) = $2.81.

c. rs = D̂ 1 /P0 + g = $2.81/$36.00 + 0.08 = 15.8%.

Retained earnings $18,000,000

c. Break point from using debt:

12% break point = ($12 million + $12 million)/0.6 = $40 million.

b. Current EPS $5.40

Alternatively, EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.

11-26 a. Common equity needed: 0.50($135,000,000) = $67,500,000.

New equity needed $67,500,000