Chapter 11: Cost of Capital
11-38
CP 11-1. (Continued)
g.
Percent
15%
13.5%
10%
A
B
C
D
5%
0
25
50
75
100
Amount of Capital ($ millions)
Top bar represents return on investment
Kmc
12.16%
11.63%
11.30%
11.20%
10.5%
Chapter 11: Cost of Capital
11-39
Comprehensive Problem 2
Garner Data Systems (cost of capital with changing financial needs) (LO1) Garner Data
Systems is a very large company with common stock listed on the New York Stock Exchange
and bonds traded over-the-counter. As of the current balance sheet, it has three bond issues
outstanding:
Expiration
$50 million of 9% series ……………………………. 2019
$100 million of 6% series ………………………….. 2016
$150 million of 4% series ………………………….. 2013
The vice-president of finance is planning to sell $150 million of bonds to replace the debt due
to expire in 2013. At present, market yields on similar Baa bonds are 11.2 percent. Garner also
has $60 million of 6.9 percent noncallable preferred stock outstanding, and it has no intentions of
selling any preferred stock at any time in the future. The preferred stock is currently priced at
$68 per share, and its dividend per share is $6.30.
The company has had very volatile earnings, but its dividends per share have had a very
stable growth rate of 8.5 percent and this will continue. The expected dividend (D1) is $2.10 per
share, and the common stock is selling for $60 per share. The company’s investment banker has
quoted the following flotation costs to Garner: $1.80 per share for preferred stock and $3 per
share for common stock.
On the advice of its investment banker, Garner has kept its debt at 50 percent of assets and its
equity at 50 percent. Garner sees no need to sell either common or preferred stock in the
foreseeable future as it has generated enough internal funds for its investment needs when these
funds are combined with debt financing. Garner’s corporate tax rate is 35 percent.
Compute the cost of capital for the following:
a. Bond (debt) (Kd).
b. Preferred stock (Kp).
c. Common equity in the form of retained earnings (Ke).
d. New common stock (Kn).
e. Weighted average cost of capital.
Chapter 11: Cost of Capital
11-40
CP 11-2. Solution
Cost of Capital with
Changing Financial Needs
Garner Data Systems
a. The before tax cost of debt will be equal to the market
rate of 11.2%. The student must realize that the historical
b. The fact that the preferred stock carries a coupon rate of
c. Ke = (D1/P0) + g
d. Kn = (D1/P0 – F)) + g
Chapter 11: Cost of Capital
CP 11-2. (Continued)
e. Only those sources of capital that are expected to be used
as long-run optimum components of the capital structure
should be included in the weighted average cost of
Cost
(aftertax)
Weights
Weighted
Cost
Debt (Kd) ……………………….
Common equity (Ke)
(retained earnings) ………….
Weighted average cost
of capital (Ka) ……………….
7.28%
12.00
50%
50
3.64%
6.00
9.64%
Appendix
11A-1. Capital asset pricing model (LO3) Assume that Rf = 6 percent and Km = 10 percent.
Compute Kj for the following betas, using Formula 11A-2.
a. 0.7
b. 1.4
c. 1.7
Chapter 11: Cost of Capital
11A–1
Solution:
a. Kj = Rf + β (Km – Rf)
= 6% + .7 (10% – 6%)
= 6% + .7 (4%)
= 6% + 2.8%
= 8.8%
b. Kj = 6% + 1.4 (10% – 6%)
= 6% + 1.4 (4%)
= 6% + 5.6%
= 11.6%
c. Kj = 6% + 1.7 (10% – 6%)
= 6% + 1.7 (4%)
= 6% + 6.8%
= 12.8%
11A-2. Capital asset pricing model (LO3) In the preceding problem, assume an increase in
interest rates changes Rf to 7.0 percent, and the market risk premium (Km – Rf) changes
to 6.5 percent. Compute Kj for the three betas of 0.7, 1.4, and 1.7.
Chapter 11: Cost of Capital
11A–2.
Solution:
a. Kj = 7% + .7 (6.5%)
= 7% + 4.55%
= 11.55%
b. Kj = 7% + 1.4 (6.5%)
= 7% + 9.1%
= 16.1%
c. Kj = 7% + 1.7 (6.5%)
= 7% + 11.05%
= 18.05%