Chapter 11

The Cost of Capital

Questions
1. From what sources can a company raise capital? Do these different sources of capital all
charge the same rate? Why or why not?
A company can borrow from owners, preferred stockholders, banks, nonbank lenders,
suppliers, and the company itself. They all have different lending rates. These lenders all
charge different rates because they all have different risk exposures and different supply and
demand schedules for their lending funds.
3. What are the two different ways to estimate the cost of equity for a firm?
The two ways to estimate the cost of equity are the dividend model and the security market
line. If you have sufficient information you can use the average of the two models or pick the
one that seems most appropriate. Usually the most appropriate model is the security market
line because it can handle the potential other investment opportunities of the lender.
Lender’s pick across a wide variety of stocks and the security market line determines the
appropriate rate for the level of risk of the investment.
4. Should retained earnings reinvested in the company have a zero cost of capital because it
generates the funds internally and the company does not need to pay itself for borrowing
money? If not, why?
These funds should not have a zero cost. The funds have an opportunity cost (the
shareholders could be paid this money via dividends instead of reinvesting in the company).
Therefore there is a cost associated with using these funds and thus a zero cost of capital is
inappropriate.
5. When calculating the cost of capital, why is it that the company only adjusts the cost of
debt for taxes?
Interest expense for debt loans is a deductible expense of the firm and is part of the income
statement used for determining the taxable income of a company. Payment of dividends to
owners is not a business expense but considered a return of permanent capital to investors.
Thus it does not appear on the income statement. So only debt has a tax impact, and thus
only debt is adjusted for taxes in the cost of capital.
6. What are the two ways to estimate the percentage (weights) of funds that a company has
received from lenders and owners? Which is more appropriate?
The two methods are book value and market value for estimating the components (weights)
of the cost of capital. The preferred choice is market value.
7. Why not use a single WACC for all company projects?
If all projects are assigned the same discount rate we can make some poor decisions on
which projects to accept and which to reject. We will tend to pick high risk projects and
reject low risk projects.
8. What are the types of errors a manager can make if he or she does not assign individual
WACCs to each potential project?
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By assigning the same discount rate to every project, a manager will tend to reject low risk
projects, despite their positive NPV if assigned the appropriate discount rate for the level of
risk, and accept high risk projects despite their negative NPV if assigned the appropriate
discount rate for the level of risk.

Problems

2. WACC. Grey’s Pharmaceuticals has a new project that will require funding of $4 million. The
company has decided to pursue an all-debt scenario. Grey’s has made an agreement with
four lenders for the needed financing. These lenders will advance the following amounts
and interest rates:

What is the weighted average cost of capital for the $4,000,000?

ANSWER
WACC = ($1.5 / $4) × 0.11 + ($1.2 / $4) × 0.09 + ($1 / $4) × 0.07 + ($0.3 / $4) × 0.08

WACC = 0.375 × 0.11 + 0.3 × 0.09 + 0.25 × 0.07 + 0.075 × 0.08

WACC = 0.04125 + 0.0270 + 0.0175 + 0.0060 = 0.09175 = 9.175%

7. Cost of preferred stock. Kyle is raising funds for his company by selling preferred stock. The
preferred stock has a par value of $100 and a dividend rate of 6%. The stock is selling for $80
in the market. What is the cost of preferred stock for Kyle?

ANSWER
The dividend is $100 × 0.06 = $6.00

And with a price of $80 the cost of preferred stock is $6/$80 = 0.075 or 7.5%

8. Cost of preferred stock. Kyle hires Wilson Investment Bankers to sell the preferred stock
from Problem 7. Wilson charges a fee of 3% on the sale of preferred stock. What is the cost
of preferred stock for Kyle using the investment banker?

ANSWER
The dividend remains the same but the proceeds are $80 × (1 – 0.03) or $77.60 so the cost of
preferred stock is now, $6/$77.60 = 0.0773 or 7.73%

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9. Cost of equity: SML. Stan is expanding his business and will sell common stock for the
needed funds. If the current risk-free rate is 4% and the expected market return is 12%,
what is the cost of equity for Stan if the beta of the stock is
a. 0.75?
b. 0.90?
c. 1.05?
d. 1.20?

ANSWER
a. Using the security market line we have,

E(ri) = rf + βi (E(rm) – rf)

Cost of Equity = E(ri) = 0.04 + 0.75 (0.12 – 0.04)

Cost of Equity = 0.04 + 0.75 (0.08) = 0.04 + 0.06 = 0.10 or 10%

b. Using the security market line we have,

E(ri) = rf + βi (E(rm) – rf)

Cost of Equity = E(ri) = 0.04 + 0.90 (0.12 – 0.04)

Cost of Equity = 0.04 + 0.90 (0.08) = 0.04 + 0.072 = 0.112 or 11.2%

c. Using the security market line we have,

E(ri) = rf + βi (E(rm) – rf)

Cost of Equity = E(ri) = 0.04 + 1.05 (0.12 – 0.04)

Cost of Equity = 0.04 + 1.05 (0.08) = 0.04 + 0.084 = 0.124 or 12.4%

d. Using the security market line we have,

E(ri) = rf + βi (E(rm) – rf)

Cost of Equity = E(ri) = 0.04 + 1.20 (0.12 – 0.04)

Cost of Equity = 0.04 + 1.20 (0.08) = 0.04 + 0.096 = 0.136 or 13.6%

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11. Book value versus market value components. Compare Trout, Inc. with Salmon Enterprises,
using the balance sheet of Trout and the market data of Salmon for the weights in the
weighted average cost of capital.
Trout, Inc.

Current Assets: $2,000,000 Current Liabilities: $1,000,000

Long-term Assets: $7,000,000 Long-Term Liabilities: $5,000,000

Total Assets $9,000,000 Owner’s Equity: $3,000,000

Salmon Enterprises

Bonds Outstanding 3,000 selling at $980

Common Stock Outstanding 260,000 selling at $23.40

If the after-tax cost of debt is 8% for both companies and the cost of equity is 12%. Which
company has the higher WACC?

ANSWER
Trout, Inc. Component Weights,

Debt = $5,000,000) / $8,000,000 = 0.625

Equity = $3,000,000 / $8,000,000 = 0.375

Salmon Enterprises Component Weights,

Market Value of Debt = $980 × 3,000 = $2,940,000

Market Value of Equity = $23.40 × 260,000 = $6,084,000

Debt Component = $2,940,000 / ($2,940,000 + $6,084,000) = 0.3258

Equity Component = $6,084,000 / ($2,940,000 + $6,084,000) = 0.6742

WACC for Trout = 0.625 × 8% + 0.375 × 12% = 9.5%

WACC for Salmon = 0.3258 × 8% + 0.6742 × 12% = 10.6968%

12. Book value versus market value components. The CFO of DMI is trying to determine the
company’s WACC. Brad, a promising MBA, says that the company should use book value to
assign the WACC components percentages. Angela, a long-time employee and experienced
financial analyst, says the company should use market value to assign the components. The
after-tax cost of debt is at 7%, the cost of preferred stock is at 11%, and the cost of equity is
at 14%. Calculate the WACC using both the book value and market value approaches with
the following information. Which do you think is better? Why?

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DMI Company

Balance Sheet

(in thousands)

Current Assets: $32,000 Current Liabilities: $0

Long-Term Assets: $66,000 Long-Term Liabilities

Bonds Payable $54,000

Owner’s Equity

Preferred Stock $12,000

Common Stock $32,000

Total Assets: $98,000 Total L & OE $98,000

Market Information

Debt Preferred Stock Common Stock

Outstanding 54,000 120,000 1,280,000

Market Price $1085 $95.40 $32.16

ANSWER
Brad’s Book Value Component Weights

Debt Component = $54,000 / $98,000 = 0.5510

Preferred Stock Component = $12,000 / $98,000 = 0.1224

Common Stock Component = $32,000/ $98,000 = 0.3265

WACC = 0.3265 × 14% + 0.1224 × 11% + 0.5510 × 7%

= 9.7755%
Angela’s Market Values

Debt Market Value = 54,000 × $1085 = $58,590,000

Preferred Stock Market Value = 120,000 × $95.40 = $11,448,000

Common Stock Market Value = $1,280,000 × $32.16 = $41,164,800

Total Market Value = $58,590,000 + $11,448,000 + $41,164,800 = $111,202,800

Angela’s Market Value Component Weights

Debt Component = $58,590,000 / $111,202,800 = 0.5269

Preferred Stock Component = $11,448,000 / $111,202,800 = 0.1029

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Common Stock Component = $41,164,800/ $111,202,800 = 0.3702

WACC = 0.3702 × 14% + 0.1029 × 11% + 0.5269 × 7% = 10.0030%

Using Angela’s approach is better because it reflects current market values of the debt, common
stock, and preferred stock and thus is at the same point in time. The historical book values used
by Brad are a collection of values over the history of the company and thus represent values at
different points in time.

13. Adjusted WACC. Lewis runs an outdoor adventure company and wants to know what effect a
tax change will have on his company’s WACC. Currently Lewis has the following borrowing
pattern:
Equity: 35% and cost of 14%
Preferred Stock: 15% and cost of 11%
Debt: 50% and cost of 10% before taxes.
What is the adjusted WACC for Lewis if the tax rate is

a. 40%?

b. 30%?

c. 20%?

d. 10%?

e. 0%?

ANSWER
a. Adjusted WACC = 0.35 × 14% + 0.15 × 11% + 0.50 × 10% × (1 – 0.40) = Adjusted WACC =
4.9% + 1.65% + 3.0% = 9.55%

b. Adjusted WACC = 0.35 × 14% + 0.15 × 11% + 0.50 × 10% × (1 – 0.30) = Adjusted WACC =
4.9% + 1.65% + 3.5% = 10.05%

c. Adjusted WACC = 0.35 × 14% + 0.15 × 11% + 0.50 × 10% × (1 – 0.20) = Adjusted WACC =
4.9% + 1.65% + 4.0% = 10.55%

d. Adjusted WACC = 0.35 × 14% + 0.15 × 11% + 0.50 × 10% × (1 – 0.10) = Adjusted WACC =
4.9% + 1.65% + 4.5% = 11.05%

e. Adjusted WACC = 0.35 × 14% + 0.15 × 11% + 0.50 × 10% × (1 – 0.00) = Adjusted WACC =
4.9% + 1.65% + 5.0% = 11.55%

14. Adjusted WACC. Clark Explorers, Inc., an engineering firm, has the following capital
structure:

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Using market value and book value (separately, of course), find the adjusted WACC for Clark
Explorers at the following tax rates:
a. 35%

b. 25%

c. 15%

d. 5%

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ANSWER
Market Value Component weights are:

Equity Market Value = $30 × 120,000 = $3,600,000

Preferred Stock Market Value = $110 × 10,000 = $1,100,000

Debt Market Value = $955 × 6,000 = $5,730,000

Total Market Value = $3,600,000 + $1,100,000 + $5,730,000 = $10,430,000

Equity Market Percent = $3,600,000 / $10,430,000 = 0.3452

Preferred Stock Market Percent = $1,100,000 / $10,430,000 = 0.1055

Debt Market Percent = $5,730,000 / $10,430,000 = 0.0.5494

Total Book Value =$3,000,000 + $1,000,000 + $6,000,000 = $10,000,000

Equity Book Percent = $3,000,000 / $10,000,000 = 0.30

Preferred Book Market Percent = $1,000,000 / $10,000,000 = 0.10

Debt Book Percent = $6,000,000 / $10,000,000 = 0.60

a. Adjusted WACC, market value

= 0.3452 × 15% + 0.1055 × 12% + 0.5494 × 9% × (1 – 0.35)

= 5.1774% + 1.2656% + 3.2139% = 9.6568%

Adjusted WACC, book value

= 0.30 × 15% + 0.10 × 12% + 0.60 × 9% × (1 – 0.35)

= 4.5% + 1.2% + 3.51% = 9.21%

b. Adjusted WACC, market value

= 0.3452 × 15% + 0.1055 × 12% + 0.5494 × 9% × (1 – 0.25)

= 5.1774% + 1.2656% + 3.7083% = 10.1512%

Adjusted WACC, book value

= 0.30 × 15% + 0.10 × 12% + 0.60 × 9% × (1 – 0.25)

= 4.5% + 1.2% + 4.05% = 9.75%

c. Adjusted WACC, market value

= 0.3452 × 15% + 0.1055 × 12% + 0.5494 × 9% × (1 – 0.15)

= 5.1774% + 1.2656% + 4.2027% = 10.6457%

Adjusted WACC, book value

= 0.30 × 15% + 0.10 × 12% + 0.60 × 9% × (1 – 0.15)

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= 4.5% + 1.2% + 4.59% = 10.29%

d. Adjusted WACC, market value

= 0.3452 × 15% + 0.1055 × 12% + 0.5494 × 9% × (1 – 0.05)

= 5.1774% + 1.2656% + 4.6972% = 11.1401%

Adjusted WACC, book value

= 0.30 × 15% + 0.10 × 12% + 0.60 × 9% × (1 – 0.05)

= 4.5% + 1.2% + 5.13% = 10.83%

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15. Apply WACC in NPV. Brawn Blenders has the following incremental cash flows for its new
project:
Category T0 T1 T2 T3

Investment –$4,000,000

NWC Change –$300,000 $300,000

Operating $1,500,000 $1,500,000 $1,500,000

cash flow

Salvage $250,000

Should Brawn Blenders accept or reject this project at an adjusted WACC of 6%, 8%, or 10%?

ANSWER
At 6% WACC we have,

NPV = –$4,300,000 + $1,500,000/1.06 + $1,500,000/1.06 2 + $2,050,000/1.063

NPV = –$4,300,000 + $1,415,094 + $1,334,995 + $1,721,220 = $171,309

Accept project if WACC is 6% or lower.

At 8% WACC we have,

NPV = –$4,300,000 + $1,500,000/1.08 + $1,500,000/1.08 2 + $2,050,000/1.083

NPV = –$4,300,000 + $1,388,889 + $1,286,008 + $1,627,356 = $2,253

Accept project if WACC is 8%.

At 10% WACC we have,

NPV = –$4,300,000 + $1,500,000/1.10 + $1,500,000/1.10 2 + $2,050,000/1.103

NPV = –$4,300,000 + $1,363,636 + $1,239,669 + $1,540,195 = –$156,499

Reject project if WACC is 10% or higher.

17. Adjusted WACC. Ashman Motors is currently an all-equity firm. It has two million shares
outstanding, selling for $43 per share. The company has a beta of 1.1, with the current risk-
free rate at 3% and the market premium at 8%. The tax rate is 35% for the company.
Ashman has decided to sell $43 million of bonds and retire half its stock. The bonds will have
a yield to maturity of 9%. The beta of the company will rise to 1.3 with the new debt. What
was the adjusted WACC of Ashman Motors before selling bonds? What is the new WACC of
Ashman Motors after selling the bonds and retiring the stock with the proceeds from the
sale of the bonds? Hint: The weight of equity before selling the bond is 100%.

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ANSWER
Before the sale of bonds the weighted average cost of capital is the cost of equity.

Re = 3% + 1.1 (8%) = 11.8% and this is the adjusted WACC.

After the sale of bonds the new cost of equity is:

Re = 3% + 1.3 (8%) = 13.4%

If Bonds sell for $43 million, the firm can retire 1 million shares, $43,000,000 / $43 = 1,000,000

The market value of equity is now $43 × 1,000,000 = $43,000,000

The market value of debt is $43,000,000

E/V = $43,000,000 / ($43,000,000 + $43,000,000) = 0.5

D/V = $43,000,000 / ($43,000,000 + $43,000,000) = 0.5

Adjusted WACC = 0.5 × 13.4% + 0.5 × 9% × (1 – 0.35) = 6.7% + 2.925% = 9.625%

21. Beta of a project. Magellan is adding a project to the company portfolio and has the
following information: the expected market return is 14%, the risk-free rate is 3%, and the
expected return on the new project is 18%. What is the project’s beta?

ANSWER
E(rproject) = 18% = 3% + βproject × (14% – 3%)

βproject = (18% – 3%) / (14% – 3%) = 15% / 11% = 1.3636

22. Beta of a project. Vespucci is adding a project to the company portfolio and has the
following information, the expected market return is 12%, the risk-free rate is 5%, and the
expected return on the new project is 10%. What is the project’s beta?

ANSWER
E(rproject) = 10% = 5% + βproject × (12% – 5%)

βproject = (10% – 5%) / (12% – 5%) = 5% / 7% = 0.7143

23. Constraints on borrowing. Country Farmlands, Inc. is considering the following potential
projects for this coming year, but has only $200,000 for these projects:
Project A: Cost $60,000, NPV $4,000, and IRR 11%

Project B: Cost $78,000, NPV $6,000, and IRR 12%

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Project C: Cost $38,000, NPV $3,000, and IRR 10%

Project D: Cost $41,000, NPV $4,000, and IRR 9%

Project E: Cost $56,000, NPV $6,000, and IRR 13%

Project F: Cost $29,000, NPV $2,000, and IRR 7%

What projects should Farmlands pick?

ANSWER
Compare the total NPV of all projects that do not violate the spending constraint of $200,000

Projects A, B, and C – NPV is $13,000 Total Cost = $176,000

Projects A, B, and D – NPV is $14,000 Total Cost = $179,000

Projects A, B, and E – NPV is $16,000 Total Cost = $194,000

Projects A, B, and F – NPV is $12,000 Total Cost = $167,000

Projects A, C, D, and E – NPV is $17,000 Total Cost = $195,000

Projects A, C, D, and F – NPV is $13,000 Total Cost = $168,000

Projects A, C, E, and F – NPV is $15,000Total Cost = $183,000

Projects A, D, E, and F – NPV is $16,000 Total Cost = $186,000

Projects B, C, D, and F – NPV is $15,000 Total Cost = $186,000

Projects B, C, and E – NPV is $15,000 Total Cost = $172,000

Projects B, D, and E – NPV is $16,000 Total Cost = $175,000

Projects C, D, E, and F – NPV is $15,000 Total Cost = $164,000

Pick Projects A, C, D, and E, highest NPV, while using almost all $200,000.

24. Constraints on borrowing. Runway Fashions, Inc. is considering the following potential
projects for the company but has only $1,000,000 in the capital budget. Which projects
should it choose?

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ANSWER
Look at all combinations of the four projects that do not violate the capital budget and select
the combination with the highest NPV. Note that there are only four combinations whose total
cost would be under the $1,000,000 budget constraint as follows:

Winter coats only NPV = $95,000: Cost = $750,000

Spring dresses and Fall suits NPV = $45,000 + $55,000 = $100,000; Cost = $1,000,000

Spring dresses and Summer sandals NPV = $45,000 + $60,000 = $105,000; Cost = $900,000

Fall suits and Summer sandals NPV = $55,000 + $60,000 = $115,000; Cost = $900,000

Select Fall suits and Summer sandals!

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