Chapter 9

The Cost of Capital

Answers to Warm-Up Exercises
E9–2 People’s Consulting Group has been asked to consult on a potential preferred stock
offering by Brave New World. This 9% preferred stock issue would be sold at its par value of
$55 per share. Flotation costs would total $3 per share. Calculate the cost of this preferred
stock.
‫ الزم تكون التوزيع بتاع سنة الوحدة بس‬Div ‫ركز علي‬
Par ‫توزيعات السنة تطلع من‬
=Div 4.95=9%*55
Np=55-3=52
9.52% = 52/4.95

E9-2
E9–3 Belle Fashions supplies garments to high street retailers. They have been paying dividends
steadily for 10 years. During that time, dividends have grown at a compound annual rate of 5%.
If Belle Fashions’s current stock price is £5.80 and the firm plans to pay a dividend of £0.70 next
year, what is the required return on Belle’s common stock?

E9-
D1 0.7
rs  g=  0.05 = 0.1706 = 17.06%
P0 5.8

E9–4 Garba Exports Ltd. is a manufacturer of cotton yarn. It has 40% debt and 60% equity in its capital
structure. The firm’s estimated after-tax cost of debt is 7% and its estimated cost of equity is 12%.
Determine the firm’s weighted average cost of capital (WACC).

WACC= ∑ w∗c

=(0.4*7)+(0.6*12)=10%
E9–5 Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The firm’s capital
structure targets the following proportions: debt, 55%; preferred stock, 10%; and common stock, 35%. If
the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%, what is Oxy’s
weighted average cost of capital (WACC)
 WACC= ∑ w∗c =(.55*6.7)+(.10*9.2)+(.35*10.6)=8.315%

 Solutions to Problems

P9–1 Concept of cost of capital and WACC Mace Manufacturing is in the process of analyzing
its investment decision-making procedures. Two projects evaluated by the firm recently involved
building new facilities in different regions, North and South. The basic variables surrounding
each project analysis and the resulting decision actions are summarized in the following table .

a. An analyst evaluating the North facility expects that the project will be financed by debt that
costs the firm 7%. What recommendation do you think this analyst will make regarding the
investment opportunity?
accepting the project because the ER exceeds the cost.
b. Another analyst assigned to study the South facility believes that funding for that project will
come from the firm’s retained earnings at a cost of 16%. What recommendation do you expect
this analyst to make regarding the investment?
Reject the project because the cost exceeds the ER.
c. Explain why the decisions in parts a and b may not be in the best interests of the firm’s investors.
The debt and equity don’t reflect a better view, so we have to use WACC.
d. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted
average cost of capital (WACC) using the data in the table.
WACC= ∑〖w*c〗= (.40*7)+(.60*16)=12.4%
e. If both analysts had used the WACC calculated in part d, what recommendations would they
have made regarding the North and South facilities?
WACC were 12.4%, rejecting project North because the ER=8% is less than WACC, and
accepting Project South because the RE=15% is bigger than WACC.
 f. Compare and contrast the analyst’s initial recommendations with your findings in part
e. Which decision method seems more appropriate? Explain why.
P9-1 Concept of cost of capital (LG 1; Basic)

e. If the hurdle rate for both projects were 12.4%, the first analyst would recommend
rejecting project North, and the second analyst would recommend accepting Project
South.
f. The proper “hurdle rate” will reflect the weights associated with the target capital
structure. The cost of equity is considerably higher than the cost of debt while the
weighted average cost of capital lies in between. Evaluating projects with the cost of
debt alone will result in accepting projects that diminish firm value. Similarly,
evaluating projects with the cost of equity alone will result in rejecting some projects
that would have added value to the firm.
P9–2 Cost of debt using both methods Currently, Jackson Real Estate Inc. can sell 10-year,
$100-par-value bonds paying annual interest at a 6% coupon rate. Jackson can sell its bonds for
$106.20 each. Jackson will incur flotation costs of $2.50 per bond in this process. The firm is in
the 25% tax bracket.
a. Find the net proceeds from sale of the bond, Nd.
Nd = 103.7$
b. Show the cash flow from the firm’s point of view over the maturity of the bond.

Time (T) Cash Flow

0 $ 103.70

1–10 –6

10 –100

c. Calculate the before-tax and after-tax costs of debt.

[($ 100−N d )] [( $ 100−103.7)]
I+ 6+
n 10
rd =
(N d + $ 100)
= rd =
(103.7+ $ 100)
=5.528%
2 2

after tax cost of debt = 5.528% (1-0.25) = 4.146%

P9–3 Before-tax cost of debt and after-tax cost of debt Jim Paige is opening his own restaurant,
and he is taking out a 10-year mortgage. Jim will borrow $400,000 from a bank, and to repay the
loan he will make 120 monthly payments (principal and interest) of $4,420.82 per month over
the next 10 years. Jim is in the 30% tax bracket. a. What is the before-tax interest rate (per year)
on Jim’s loan? b. What is the after-tax interest rate that Jim is paying?
P9-3 Before-tax cost of debt and after-tax cost of debt (LG 3; Easy)
a. PV = 400,000, PMT = –4420.82, N = 10 × 12 = 120, FV = 0
Solving for I = 0.4917% per month

So, APR will be = (1+0.004917)12 – 1 = 0.06063 or 6.063%

b. The after-tax cost of debt is given by rd × (1 – T), where T is the tax rate. So, with a tax
c. rate of 30%, the after-tax interest rate will be 6.063% × (1 – 0.3) = 4.243%

P9–4 Cost of debt using the approximation formula For each of the following $1,000-parvalue
bonds, assuming annual interest payment and a 21% tax rate, calculate the after-tax cost to
maturity, using the approximation formula.

d. P9-4 Cost of debt using the approximation formula (LG 3; Basic)

$ 1,000−N d After-tax cost of debt rd  (1T)

I+ where:
n
rd = rd = pre-tax cost of debt
N d + $ 1,000
Nd = Net proceeds from bond sale
2 n = number of years to maturity
I = Annual interest payments in dollars.
e.

Bond A Bond D
$ 1,000−$ 955 $ 1,000−$ 985
$ 90+ $ 90+
20 $ 92.25 25 $ 90.60
rd = = =9.44r%
d= = =9.13 %
$ 955+$ 1,000 $ 977.50 $ 985+$ 1,000 $ 992.50
2 2
After-tax cost of debt (21% tax rate): After-tax cost of debt:
 9.44%  (10.21)  7.46%  9.13%  (10.21)  7.21%
Bond B Bond E
 $ 1,000−$ 970 $ 1,000−$ 920
$ 100+ $ 110 +
16 $ 101.88 22 $ 113.64
rd = = =10.34
r d =% = =11.84 %
$ 970+ $ 1,000 $ 985 $ 920+ $ 1,000 $ 960
2 2
After-tax cost of debt (21% tax rate): After-tax cost of debt:
 10.34%  (10.21)  8.17%  11.84%  (10.21)  9.35%
Bond C
$ 1,000−$ 955
$ 120+
15 $ 123
rd = = =12.58 %
$ 955+ $ 1,000 $ 977.50
2
After-tax cost of debt:
 12.58%  (10.21)  9.94%
P9–7 Cost of preferred stock Mavis Taylor Corporation has just issued preferred stock. The stock
has a 6% annual dividend and a $100 par value and was sold at $98.5 per share. Flotation costs
were an additional $3 per share.
a. Calculate the cost of the preferred stock.
rp = $6 $
b. If the firm sells the preferred stock with a 10% annual dividend and net $93.00 after flotation
costs, what is its cost?
rp = $10 $

P9–8 Cost of preferred stock Determine the cost for each of the following preferred stocks.

P9-8 Cost of preferred stock (LG 4; Basic)

The cost of preferred stock is given by rp  Dp  Np, where Dp is annual preferred dividends
(in dollars) and Np is net proceeds from issuing preferred stock.
Preferred Stock Calculation
A rp  $1.5  $25  6%
B rp  4.4  58  7.59%
C rp  3  26  11.54%
D rp  12  107  11.21%
E rp  2.45  40.50  6.05%
 P9–9 Cost of common stock equity: CAPM Brigham Jewellery Corporation common stock
has a beta, b, of 1.8. The risk-free rate is 5%, and the market return is 16%.
a. Determine the risk premium on Brigham common stock.
b. Determine the required return that Brigham common stock should provide.
c. Determine Brigham’s cost of common stock equity using the CAPM.
rs RF  [b × (rm RF)]
rs 5%  1.8 × (16% 5%)
rs 5% 19.8%
rs  24.8%
a. Risk premium 19.8%
b. Rate of return 24.8%
c. Cost of common equity using the CAPM 24.8%
P9–13 WACC: Market value weights Boots Mechanics is based in Manchester, United
Kingdom. The market values and after-tax costs of various sources of capital used by the
company are shown in the following table

a. Calculate the WACC for Boots Mechanics.

b. Explain how the company can use the WACC if it wants to invest in a new project.

P9-13 WACC: Market value weights (LG 6; Basic)

a. Type of Capital Market Value Weight × Cost = Weighted Cost
20-year bond £6,000,000 0.30 × 8% = 2.40%
Common stock £4,000,000 0.20 × 14% = 2.80%
Long-term loan £10,000,000 0.50 × 10% = 5.00%
£20,000,000 1.000 Sum = 10.20%
a. WACC indicates the rate of return that any project needs to provide at the minimum. If a
project gives a return lower than the WACC, it will result in losses as the cost of capital
is more than the return provided by the project.
P9–15 WACC and target weights After careful analysis, Dexter Brothers has determined that its
optimal capital structure is composed of the sources and target market value weights shown in
the following table.

The cost of debt is 4.2%, the cost of preferred stock is 9.5%, the cost of retained earnings is
13.0%, and the cost of new common stock is 15.0%. All are after-tax rates. The company’s debt
represents 25%, the preferred stock represents 10%, and the common stock equity represents
65% of total capital on the basis of the current market values of the three components. The
company expects to have a significant amount of retained earnings available and does not expect
to sell any new common stock.
a. Calculate the WACC on the basis of historical market value weights.
b. Calculate the WACC on the basis of target market value weights.
c. Compare the answers obtained in parts a and b. Explain the differences.

P9-15 Weighted average cost of capital and target weights (LG 6; Intermediate)
a. Weighted average cost of capital (rWACC) with historical market weights:
Column → 1 2 3=1x2
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.25 4.20% 1.05%
Preferred stock 0.1 9.50% 0.95%
Common equity* 0.65 13.00% 8.45%
1.00 Sum (r WACC) = 10.45%
 b. Weighted average cost of capital (rWACC) with target market weights:
Column → 1 2 3=1x2
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.30 4.20% 1.26%
Preferred stock 0.15 9.50% 1.43%
Common equity* 0.55 13.00% 7.15%
1.00 Sum (r WACC) = 9.84%
*The firm has plenty of retained earnings available to finance new projects, so the cost
of common equity is the cost of retained earnings (13%), not the cost of new common
stock (15%)
c. Weighted average cost of capital is lower in part (b) because more weight is placed on
cheaper sources of capital (debt and preferred stock) and less on the costliest source
(common stock).
P9–16 Cost of capital GB Timbers GmbH, based in Germany, supplies timber products to
construction and manufacturing industries. The company reported after-tax earnings available to
common stock of €3,200,000. From these earnings, the management decided to pay a dividend of
€0.80 on each of its 4,000,000 common shares outstanding. The capital structure of the company
includes 30% debt, 40% common stock, and 30% preferred stock. The tax rate applicable to GB
Timbers is 30%.
a. If the market price of the common stock is €3.60 and dividends are expected to grow at a rate
of 8% per year for the foreseeable future, what is the required return on the company’s common
stock?
b. If underpricing and flotation costs on new shares of common stock amount to € 0.40 per share,
what is the company’s cost of new common stock financing?
c. The company can issue a €1.00 dividend preferred stock for a market price of €10.00 per
share. Flotation costs would amount to €0.60 per share. What is the cost of preferred stock
financing?
d. In addition, the company can issue €100-par-value, 8% coupon, 10-year bonds that can be
sold for €110 each. Flotation costs would amount to €2 per bond. Use the estimation formula to
figure the approximate cost of debt financing. e. What is the WACC?

P9-16 Cost of capital (LG 3, LG 4, LG 5, and LG 6; Challenge)

a. Cost of retained earnings:
0.80 ×(1+ 0.08)
rr = +0.08=0.32∨32 %
3.60
b. Cost of new common stock:
0.80×(1+ 0.08)
r s= +0.08=0.35∨35 %
3.60−0.40
c. Cost of preferred stock:
1
r p= =0.1064∨10.64 %
10−0.60
d. Approximate cost of debt financing:
(100−108)
8+
10
rd = =0.0692∨6.92%
(108+100)
2
After-tax cost of debt = 6.92% × (1 – 0.3) = 4.85%

e. WACC = (0.30 ×4.85%) + (0.40 ×32 %) + (0.3 ×10.64) = 17.477%