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    Student 11 Problem: 18: Cost of Debt

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    The document provides inputs used in a capital budgeting model, including the cost of debt, preferred stock, and equity. It then calculates the weighted average cost of capital (WACC) as 9.23% assuming the current capital structure. Finally, it analyzes 3 potential projects with different betas and expected returns, determining that projects A and B should be accepted since their returns exceed the WACC, while project C should be rejected since its return is lower than the WACC.

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    Student 11 Problem: 18: Cost of Debt

    Uploaded by

    FakerPlaymaker
    48 views6 pages
    The document provides inputs used in a capital budgeting model, including the cost of debt, preferred stock, and equity. It then calculates the weighted average cost of capital (WACC) as 9.23% assuming the current capital structure. Finally, it analyzes 3 potential projects with different betas and expected returns, determining that projects A and B should be accepted since their returns exceed the WACC, while project C should be rejected since its return is lower than the WACC.

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    The document provides inputs used in a capital budgeting model, including the cost of debt, preferred stock, and equity. It then calculates the weighted average cost of capital (WACC) as 9.23% assuming the current capital structure. Finally, it analyzes 3 potential projects with different betas and expected returns, determining that projects A and B should be accepted since their returns exceed the WACC, while project C should be rejected since its return is lower than the WACC.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    48 views6 pages

    Student 11 Problem: 18: Cost of Debt

    Uploaded by

    FakerPlaymaker
    The document provides inputs used in a capital budgeting model, including the cost of debt, preferred stock, and equity. It then calculates the weighted average cost of capital (WACC) as 9.23% assuming the current capital structure. Finally, it analyzes 3 potential projects with different betas and expected returns, determining that projects A and B should be accepted since their returns exceed the WACC, while project C should be rejected since its return is lower than the WACC.

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
    of 6

    Student

    Chapter: 11
    Problem: 18

    INPUTS USED IN THE MODEL

    P0 $50.00
    Net Ppf $30.00
    Dpf $3.30
    D0 $2.10
    g 7%
    B-T rd 10%
    Skye's beta 0.83
    Market risk premium, RPM 6.0%
    Risk free rate, rRF 6.5%
    Target capital structure from debt 45%
    Target capital structure from preferred stoc 5%
    Target capital structure from common stoc 50%
    Tax rate 35%
    Flotation cost for common 10%

    a. Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of preferred stock (including
    flotation costs), and the cost of equity (ignoring flotation costs). Use both the DCF method and the CAPM method to find
    the cost of equity.

    Cost of debt:

    B-T rd × (1 – T) = A-T rd
    10% 65% 6.50%

    Cost of preferred stock (including flotation costs):

    Dpf / Net Ppf = rpf


    $3.40 $30.00 11.33%

    Cost of common equity, DCF (ignoring flotation costs):

    D1 / P0 + g = rs
    $2.25 $50.00 7% 11.49%

    Cost of common equity, CAPM:

    rRF +
    b × RPM = rs
    6.5% 4.98% 11.48%

    IMPORTANT NOTE: HERE THE CAPM AND THE DCF METHODS PRODUCE APPROXIMATELY THE SAME COST OF
    EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE SAME RESULT.
    ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS.
    IMPORTANT NOTE: HERE THE CAPM AND THE DCF METHODS PRODUCE APPROXIMATELY THE SAME COST OF
    EQUITY. THAT OCCURRED BECAUSE WE USED A BETA IN THE PROBLEM THAT FORCED THE SAME RESULT.
    ORDINARILY, THE TWO METHODS WILL PRODUCE SOMEWHAT DIFFERENT RESULTS.

    b. Calculate the cost of new stock using the DCF model.

    D0 × (1 + g) / P0 × (1 – F) + g = re
    $2.25 $45.00 7% 12%

    c. What is the cost of new common stock based on the CAPM? (Hint: Find the difference between re and rs as
    determined by the DCF method and add that differential to the CAPM value for rs.)

    rs + Differential = re
    11.48% 0.50% 12%

    Again, we would not normally find that the CAPM and DCF methods yield identical results.

    d. Assuming that Gao will not issue new equity and will continue to use the same capital structure, what is the
    company's WACC?

    wd 45.0%
    wpf 5.0%
    ws 50.0%
    100.0%

    wd × A-T rd + wpf × rpf + ws × rs = WACC


    2.93% 0.57% 5.74% 9.23%

    e. Suppose Gao is evaluating three projects with the following characteristics:

    (1) Each project has a cost of $1 million. They will all be financed using the target mix of long-term debt, preferred
    stock, and common equity. The cost of the common equity for each project should be based on the beta estimate
    the project. All equity will come from reinvested earnings.

    (2) Equity invested in Project A would have a beta of 0.5. The project has an expected return of 9.0%.

    (3) Equity invested in Project B would have a beta of 1.0. The project has an expected return of 10.0%.

    (4) Equity invested in Project C would have a beta of 2.0. The project has an expected return of 11.0%.

    Analyze the company’s situation and explain why each project should be accepted or rejected.

    Beta rs rps rd(1 – T) WACC


    Project A 0.5 9.50% 3.00% 32.50% 3.54%
    Project B 1.0 12.50% 6.00% 65.00% 6.34%
    Project C 2.0 18.50% 12.00% 130.00% 11.93%
    The expected returns on Projects A and B both exceed their risk-adjusted WACCs, so they should be accepted. However, Project
    C's WACC exceeds its expected rate of return, so it should be rejected.
    ed stock (including
    APM method to find

    AME COST OF
    ME RESULT.
    and rs as

    what is the

    m debt, preferred
    on the beta estimated for

    Expected
    return on
    project
    9%
    10%
    11%
    ed. However, Project

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