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382 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
And solving via a calculator we have: set P/Y = 2; C/Y = 2
INPUTS 60 ? v75 6 100
Variables N I/Y PV PMT FV
OUTPUT 16.05%
b. The price of an individual bond is $54,000,000 / 600,000 = $90 so,
c. The price of an individual bond is $66,000,000 / 600,000 = $110 so,
d. The price of an individual bond is $75,000,000 / 600,000 = $125 so,
5. Cost of debt with fees. Kenny Enterprises will issue the same debt in Problem 3, but now will
use an investment bank that charges $25 per bond for their services. What is the new cost
of debt for Kenny Enterprises at a market price of
a. $920?
b. $1,000?
c. $1,080?
d. $1,173?
Chapter 11 ◼ The Cost of Capital 383
ANSWER
a. If the bond sells for $920 and Kenny pays $25 per bond, the net proceeds are $895:
b. If the bond sells for $1,000 and Kenny pays $25 per bond, the net proceeds are $975:
c. If the bond sells for $1,080 and Kenny pays $25 per bond, the net proceeds are $1,055:
d. If the bond sells for $1,173 and Kenny pays $25 per bond, the net proceeds are $1,148:
Chapter 11 ◼ The Cost of Capital 385
© 2018 Pearson Education, Inc.
And solving via a calculator we have: set P/Y = 2; C/Y = 2
INPUTS 60 ? –122.50 6 100
Variables N I/Y PV PMT FV
OUTPUT 9.69%
Chapter 11 ◼ The Cost of Capital 387
© 2018 Pearson Education, Inc.
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%
Chapter 11 ◼ The Cost of Capital 389
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,
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?
390 Brooks ◼ Financial Management: Core Concepts, 4e
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
Chapter 11 ◼ The Cost of Capital 391
© 2018 Pearson Education, Inc.
Preferred Stock Component = $11,448,000 / $111,202,800 = 0.1029
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
14. Adjusted WACC. Clark Explorers, Inc., an engineering firm, has the following capital
structure:
392 Brooks ◼ Financial Management: Core Concepts, 4e
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%
Chapter 11 ◼ The Cost of Capital 393
ANSWER
Market Value Component weights are:
a. Adjusted WACC, market value
b. Adjusted WACC, market value
c. Adjusted WACC, market value
394 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
= 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%
396 Brooks ◼ Financial Management: Core Concepts, 4e
flow
Salvage
$400,000
At what adjusted WACCs will the company accept this project? Hint: Find the IRR of the project,
and use it as the maximum adjusted WACC for accepting the project.
ANSWER
Find the IRR.
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%.
ANSWER
