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P9-13. WACC—book weights
LG 6; Basic
a.
Type of Capital Book Value Weight Cost Weighted Cost
Long-term debt $700,000 0.500 5.3% 2.650%
b. The WACC is the rate of return that the firm must receive on long-term projects to maintain the value
P9-14. WACC—book weights and market weights
LG 6; Intermediate
a. Book value weights:
Type of Capital Book Value Weight Cost Weighted Cost
Long-term debt $4,000,000 0.784 6.00% 4.704%
b. Market value weights:
Type of Capital Market Value Weight Cost Weighted Cost
Long-term debt $3,840,000 0.557 6.00% 3.342%
c. The difference lies in the two different value bases. The market value approach yields the better value
P9-15. WACC and target weights
LG 6; Intermediate
a. Historical market weights:
Type of Capital Weight Cost Weighted Cost
Long-term debt 0.25 7.20% 1.80%
b. Target market weights:
Type of Capital Weight Cost Weighted Cost
© 2015 Pearson Education, Inc.
Chapter 9 The Cost of Capital 179
Long-term debt 0.30 7.20% 2.160%
c. Using the historical weights, the firm has a higher cost of capital due to the weighting of the more
P9-16. Cost of capital
LG 3, 4, 5, 6; Challenge
a. Cost of retained earnings
$1.26(1 0.06) $1.34
0.06 3.35% 6% 9.35%
$40.00 $40.00
r
r+
= + = = + =
b. Cost of new common stock
$1.26(1 0.06) $1.34
0.06 4.06% 6% 10.06%
$40.00 $7.00 $33.00
s
r+
= + = = + =
-
c. Cost of preferred stock
$2.00 $2.00 9.09%
$25.00 $3.00 $22.00
p
r= = =
-
d.
$1,000 $1,175
$100 $65.00
55.98%
$1,175 $1,000 $1,087.50
2
d
r
-
+
= = =
+
e. WACC (0.40)(3.59%) (0.10)(9.09%) (0.50)(9.35%)
P9-17. Calculation of individual costs, WACC, and WMCC
LG 3, 4, 5, 6; Challenge
a. After-tax cost of debt
Chapter 9 The Cost of Capital 180
b. Cost of preferred stock:
p
p
p
D
rN
=
$8 12.70%
$63
p
r= =
c. Cost of new common stock equity:
Solve for g:
N 4, PV $2.85, FV $3.75
Solve for I: 7.10%
Net Proceeds: Current price – Price adjustment – Floatation cost
$50 $5 $3 $42
rn $4.00 $42.00 0.0710 0.0952 0.0710 0.1662 $16.62%
d. WACC: Long-term debt 0.40 6.51% 2.60%
P9-18. Personal finance problem: Weighted-average cost of capital
LG 6; Intermediate
Rate
[1]
Outstanding Loan Balance
[2]
Weight
[2] 64,000 [3]
WACC
[1] [3]
Loan 1
6.00%
$ 20,000
31.25%
1.88%
P9-19. Calculation of individual costs and WACC
LG 3, 4, 5, 6; Challenge
a. After-tax cost of debt
Chapter 9 The Cost of Capital 181
($1,000 $940)
$80 $80 $3
20 8.56%
($940 $1,000) $970
2
d
r
-
++
= = =
+
b. Preferred stock:
$7.60 8.44%
$90
p
p
p
p
D
rN
r
=
= =
c. Retained earnings:
1
0
= ($7.00 ÷ $90) + 0.06 = 0.0778 + 0.0600 = 0.1378 or 13.78%
r
D
r g
P
= +
New common stock:
1
= [$7.00 ÷ ($90 $7 $5)] + 0.06
= [$7.00 ÷ $78] + 0.06 = 0.0897 + 0.0600 = 0.1497 or 14.97%
n
n
D
r g
N
= +
- -
Type of Capital
Target
Capital
Structure %
Cost of
Capital
Source
Weighted
Cost
2. With retained earnings
3. With new common stock
P9-20. Weighted-average cost of capital
LG 6; Intermediate
Chapter 9 The Cost of Capital 182
c. They are affected because, under the revised capital structure, there is more debt financing. Bond
d. WACC 0.70 (0.06) 0.30 (0.16) 0.042 0.048 0.09, or 9%
e. Increasing the percentage of debt financing increases the risk of the company not being able to make its
P9-21. Ethics problem
LG 1; Intermediate
Case
Case studies are available on www.myfinancelab.com.
Making Star Products’ Financing/Investment Decision
The Chapter 9 case, Star Products, is an exercise in evaluating the cost of capital and available investment
a. Cost of financing sources
Debt:
(1) Below $450,000:
Calculator Method:
© 2015 Pearson Education, Inc.
Chapter 9 The Cost of Capital 183
Chapter 9 The Cost of Capital 184
Long-term debt
common equity
Break point
$450,000
(1) BP $1,500,000
0.30
$1,500,000
(2) BP $2,500,000
0.60
AF
W
=
= =
= =
(3) Based on the information above, cheaper debt financing is exhausted when the value
of projects accepted exceeds $1,500,000. Retained earnings can finance $2,500,000 of new
projects without having to issue additional debt. In the prior calculation of weighted average costs
of capital, a weighted average costs of capital for cheap debt and external equity financing was
not needed because Star Products runs out of financing from cheap debt first.
d. Investments are ranked in terms of their rate of return. The project with the highest rate of return is Project C,
e. (1) Cheap debt and equity
(2) Cheap debt and half as much retained earnings
(3) Cheap debt and all $1,500,000 of retained earnings (illustrated in Part d)
(4) Limited total debt and $1,500,000 of retained earnings
© 2015 Pearson Education, Inc.
Chapter 9 The Cost of Capital 185
Spreadsheet Exercise
Group Exercise
Group exercises are available on www.myfinancelab.com.
Accurately measuring the cost of capital is the topic of this chapter. The group exercise will use current
information from the shadow firm to provide details for each group’s fictitious firm. The balance sheet is the
source of this information and the assignment begins with an investigation into the shadow firm’s debt/equity mix.
Integrative Case 4: Eco Plastics Company
This case focuses on determination of the cost of capital for a firm. The student determines the cost of individual
sources of financing, including long-term debt, preferred stock, and common stock. The cost of debt is adjusted for
a. Cost of debt:
Proceeds from sale of $1,000 par value bond:
b. Cost of preferred stock: rp Dp Np
c. Cost of common stock: rj RF [bj (rm RF)]
© 2015 Pearson Education, Inc.
Chapter 9 The Cost of Capital 186
d. Weighted average cost of capital: ra (wi ri) (wp rp) (ws rn)
e. 1. Change in risk Premium:
Change in beta market risk premium
2. Revised weighted average cost of capital: ra (wi x ri) (ws x rn)
3. Eco Plastics’ CFO should retain the cheaper current financial structure. Replacing preferred stock
© 2015 Pearson Education, Inc.
