Financial Management Chapter 11 Answer
Financial Management Chapter 11 Answer
Financial Management Chapter 11 Answer
Solutions to Problems
n
I M
Bo =
+
t
n
t =1 (1 + k) (1 + k)
15 $120 $1,000
+
$980 =
t
15
t =1 (1 + k) (1 + k)
Step 1: Try 12%
V = 120 (6.811) + 1,000 (0.183)
V = 817.32 + 183
V = $1,000.32
(Due to rounding of the PVIF, the value of the bond is 32 cents greater than expected. At the
coupon rate, the value of a $1,000 face value bond is $1,000.)
282
Try 13%:
V = 120 (6.462) + 1,000 (0.160)
V = 775.44 + 160
V = $935.44
The cost to maturity is between 12% and 13%.
Step 2: $1,000.32 $935.44 = $64.88
Step 3: $1,000.32 $980.00 = $20.32
Step 4: $20.32 $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31 (1 0.40) = 7.39% = after-tax cost of debt
Calculator solution: 12.30%
(d) Approximate before-tax cost of debt
kd =
kd =
$1,000 Nd
n
Nd + $1,000
2
I+
($1,000 $980)
15
($980 + $1,000)
2
$120 +
kd = $121.33 $990.00
kd = 12.26%
Approximate after-tax cost of debt = 12.26% (1 0.4) = 7.36%
(e) The interpolated cost of debt is closer to the actual cost (12.2983%) than using the
approximating equation. However, the short cut approximation is fairly accurate and
expedient.
P11-3. LG 2: Cost of DebtUsing the Approximation Formula:
Basic
kd =
$1,000 Nd
n
Nd + $1,000
2
I+
Bond A
ki = kd (1 T)
Chapter 11
kd =
$1,000 $955
$92.25
20
=
= 9.44%
$955 + $1,000
$977.50
2
$90 +
kd =
$1,000 $970
$101.88
16
=
= 10.34%
$970 + $1,000
$985
2
$100 +
kd =
$1,000 $955
$123
15
=
= 12.58%
$955 + $1,000
$977.50
2
$120 +
kd =
$1,000 $985
$90.60
25
=
= 9.13%
$985 + $1,000
$992.50
2
$90 +
kd =
$1,000 $920
$113.64
22
=
= 11.84%
$920 + $1,000
$960
2
$110 +
283
284
kd =
$1,000 Nd
n
Nd + $1,000
2
I+
ki = kd (1 T)
Alternative A
kd =
$1,000 $1,220
$76.25
16
=
= 6.87%
$1,220 + $1,000
$1,110
2
$90 +
kd =
$1,000 $1,020
$66.00
5
=
= 6.54%
$1,020 + $1,000
$1,010
2
$70 +
kd =
$1,000 $970
$64.29
7
=
= 6.53%
$970 + $1,000
$985
2
$60 +
kd =
$1,000 $895
$60.50
10
=
= 6.39%
$895 + $1,000
$947.50
2
$50 +
(b)
$12.00
= 12.63%
$95.00
$10.00
kp =
= 11.11%
$90.00
kp =
Chapter 11
kp
kp
kp
kp
kp
=
=
=
=
=
Calculation
$11.00 $92.00
3.20 34.50
5.00 33.00
3.00 24.50
1.80 17.50
=
=
=
=
=
11.96%
9.28%
15.15%
12.24%
10.29%
D1 + g
Nn
Intermediate
(a)
D2006
= FVIFk%,4
D2002
$3.10
g=
= 1.462
$2.12
g=
From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).
Calculator solution: 9.97%
(b) Nn = $52 (given in the problem)
D
(c) k r = 2007 + g
P0
$3.40
+ 0.10 = 15.91%
$57.50
D
k r = 2007 + g
Nn
kr =
(d)
kr =
$3.40
+ 0.10 = 16.54%
$55.00
285
286
D1
+g
P0
kn =
D1
+g
Nn
Firm
Calculation
Book Value
$700,000
50,000
650,000
$1,400,000
Weight
0.500
0.036
0.464
1.000
Cost
5.3%
12.0%
16.0%
Weighted Cost
2.650%
0.432%
7.424%
10.506%
(b) The WACC is the rate of return that the firm must receive on long-term projects to maintain
the value of the firm. The cost of capital can be compared to the return for a project to
determine whether the project is acceptable.
Chapter 11
287
Book Value
$4,000,000
40,000
1,060,000
$5,100,000
Weight
0.784
0.008
0.208
Cost
6.00%
13.00%
17.00%
Weighted Cost
4.704%
0.104%
3.536%
8.344%
Market Value
$3,840,000
60,000
3,000,000
$6,900,000
Weight
0.557
0.009
0.435
Cost
6.00%
13.00%
17.00%
Weighted Cost
3.342%
0.117%
7.395%
10.854%
(c) The difference lies in the two different value bases. The market value approach yields the
better value since the costs of the components of the capital structure are calculated using the
prevailing market prices. Since the common stock is selling at a higher value than its book
value, the cost of capital is much higher when using the market value weights. Notice that the
book value weights give the firm a much greater leverage position than when the market
value weights are used.
P11-13. LG 4: WACC and Target Weights
Intermediate
(a) Historical market weights:
Type of Capital
L-T Debt
Preferred stock
Common stock
Weight
0.25
0.10
0.65
Cost
7.20%
13.50%
16.00%
Weighted Cost
1.80%
1.35%
10.40%
13.55%
Weight
0.30
0.15
0.55
Cost
7.20%
13.50%
16.00%
Weighted Cost
2.160%
2.025%
8.800%
12.985%
(c) Using the historical weights the firm has a higher cost of capital due to the weighting of the
more expensive common stock component (0.65) versus the target weight of (0.55). This
over-weighting in common stock leads to a smaller proportion of financing coming from the
significantly less expense L-T debt and the lower costing preferred stock.
288
$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 3.35% + 6% = 9.35%
$40.00
$40.00
$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 4.06% + 6% = 10.06%
$40.00 $7.00
$33.00
$2.00
$2.00
=
= 9.09%
$25.00 $3.00 $22.00
$1,000 $1,175
$65.00
5
(d) kd =
=
= 5.98%
$1,175 + $1,000
$1,087.50
2
ki = 5.98% (1 0.40) = 3.59%
$100 +
(e)
BPcommon equity =
(f)
Chapter 11
289
kd =
kd =
($1,000 Nd )
n
(Nd + $1,000)
2
I+
($1,000 $950)
$100 + $5
10
=
= 10.77%
($950 + $1,000)
$975
2
$100 +
ki = 10.77 (l 0.40)
ki = 6.46%
Cost of Preferred Stock: kp =
kp =
Dp
Np
$8
= 12.70%
$63
D2007
= FVIFk%,4
D2002
g=
$4.00
= 1.403
$2.85
D1
+g
P0
From FVIF table, the factor closest to 1.403 occurs at 7% (i.e., 1.404 for 5 years). Calculator
solution: 7.01%
kr =
$4.00
+ 0.07 = 15.00%
$50.00
$4.00
+ 0.07 = 16.52%
$42.00
AFj
Wj
[$7,000,000 (1 0.6* )]
= $5,600,000
0.50
Between $0 and $5,600,000, the cost of common stock equity is 15% because all common
stock equity comes from retained earnings. Above $5,600,000, the cost of common stock
equity is 16.52%. It is higher due to the flotation costs associated with a new issue of
common stock.
*
The firm expects to pay 60% of all earnings available to common shareholders as dividends.
290
L-T Debt
0.40 6.46%
Preferred stock 0.10 12.70%
Common stock 0.50 15.00%
WACC
=
=
=
=
2.58%
1.27%
7.50%
11.35%
=
=
=
=
2.58%
1.27%
8.26%
12.11%
kd =
kd =
($1,000 Nd )
n
(Nd + $1,000)
2
I+
($1,000 $940)
$80 + $3
20
=
= 8.56%
($940 + $1,000)
$970
2
$80 +
ki = kd (1 t)
ki = 8.56% (1 0.40)
ki = 5.1%
Preferred Stock:
Dp
Np
$7.60
kp =
= 8.44%
$90
kp =
Common Stock:
Dj
+g
Nn
$7.00
kp =
= 0.06 = 0.1497 = 14.97%
$78
kn =
Retained Earnings:
D1
+g
P0
$7.00
kp =
= 0.06 = 0.1378 = 13.78%
$90
kr =
Chapter 11
AFj
Wi
[$100,000 ] = $200,000
(1) BPcommon equity =
0.50
Target
Type of Capital
Capital
Structure %
(2) WACC equal to or below
$200,000 BP:
Long-term debt
0.30
Preferred stock
0.20
Common stock equity
0.50
291
0.30
0.20
0.50
Cost of
Capital
Source
Weighted
Cost
5.1%
1.53%
8.4%
1.68%
13.8%
6.90%
WACC = 10.11%
5.1%
1.53%
8.4%
1.68%
15.0%
7.50%
WACC = 10.71%
Cost
%
6
8
Range of
New Financing
$0$320,000
$320,001
and above
Preferred stock
17
$0 and above
Common stock
equity
20
24
$0$200,000
$200,001
and above
Breaking
Point
$320,000 0.40 = $800,000
Range of Total
New Financing
$0$800,000
Greater than
$800,000
Greater than $0
$200,000 0.40 = $500,000
$0$500,000
Greater than
$500,000
292
(c) WACC
Source of
Capital
(1)
Debt
Preferred
Common
Target
Proportion
(2)
0.40
0.20
0.40
$500,000$800,000
Debt
Preferred
Common
0.40
0.20
0.40
Greater than
$800,000
Debt
Preferred
Common
0.40
0.20
0.40
Range of Total
New Financing
$0$500,000
Weighted Cost
(2) (3)
Cost %
(3)
(4)
6
2.40%
17
3.40%
20
8.00%
WACC = 13.80%
6%
2.40%
17%
3.40%
24%
9.60%
WACC = 15.40%
8%
3.20%
17%
3.40%
24
9.60%
WACC = 16.20%
Initial
Investment
$200,000
100,000
300,000
200,000
100,000
400,000
300,000
600,000
100,000
IRR
23%
22
21
19
17
16
15
14
13
24
Cumulative
Investment
$200,000
300,000
600,000
800,000
900,000
1,300,000
1,600,000
2,200,000
2,300,000
23
22
21
20
Weighted Average
Cost of
Capital/Return (%)
19
18
17
16
15
14
13
12
0
300
600
900
1200
1500
1800
2100
2400
2700
Chapter 11
293
(e) The firm should accept investments E, C, G, A, and H, since for each of these, the internal
rate of return (IRR) on the marginal investment exceeds the weighted marginal cost of capital
(WMCC). The next project (i.e., I) cannot be accepted since its return of 16% is below the
weighted marginal cost of the available funds of 16.2%.
P11-18. LG 4, 5, 6: IntegrativeWACC, WMCC, and IOC
Challenge
= (0.5)(6.3%) + (0.1)(12.5%) + (0.4)(15.3%)
= 3.15% + 1.25% + 6.12%
= 10.52%
15
H
14
Weighted Average
Cost of
Capital/Return (%)
G
13
WMCC
12
M
A
IOS
11
10
0
200
400
600
800
1000
1200
1400
1600
1800
2000
294