CP 11-1. Solution:
Medical Research Corporation
a. Kd = Yield (1 – T)
= 11% (1 – .30) = 11% (.70) = 7.70%
Cost
(aftertax) Weights
Weighted
Cost
Debt (Kd)……………………….. 7.70% 40% 3.08%
c. First compute Kn
Kn = (D1/(P0 – F) + g
Cost
(aftertax) Weights
Weighted
Cost
Debt (Kd)……………………….. 7.70% 40% 3.08%
(Kn)……………………………..
e. First compute the new value for Kd.
Kd = Yield (1 – T)
Cost
(aftertax) Weights
Weighted
Cost
Debt (Kd)……………………….. 9.10% 40% 3.64%
(Kmc).….……………………….
f. The answer is $50 million.
Return on
Investment
Marginal Cost
of Capital
1st $25 million 18.0% > 11.84%
$25 million – $50 million 14.0% > 12.13%
CP 11-1. (Continued)
g. The top bar represents return on investment.
The dotted line represents marginal cost of capital (Kmc).
Percent (return)
18%
14%
Comprehensive Problem 2
Masco Oil and Gas Company 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:
$150 million of 10 percent series……………….…. 2021
$50 million of 7 percent series…………….…….…. 2015
$75 million of 5 percent series…………………..…. 2011
The vice president of finance is planning to sell $75 million of bonds next year to replace the
debt due to expire in 2011. Present market yields on similar Baa-rated bonds are 12.1 percent.
Masco also has $90 million of 7.5 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 $80 per share, and its dividend per share is $7.80.
The company has had very volatile earnings, but its dividends per share have had a very
stable growth rate of 8 percent and this will continue. The expected dividend (D1) is $1.90 per
share, and the common stock is selling for $40 per share. The company’s investment banker has
quoted the following flotation costs to Masco: $2.50 per share for preferred stock and $2.20 per
share for common stock.
On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its
equity at 50 percent. Masco sees no need to sell either common or preferred stock in the
12.69% Kmc
foreseeable future as it has generated enough internal funds for its investment needs when these
funds are combined with debt financing. Masco’s corporate tax rate is 40 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.
CP 11-2. Solution
Masco Oil and Gas Company
a. The before tax cost of debt will be equal to the market
rate of 12.1 percent. The student must realize that the
b. The fact that the preferred stock carries a coupon rate of
7.5 percent does not influence Kp, which is dependent
upon current prices and the dividend.
c. Ke = (D1/P0) + g
d. Kn = (D1/P0 – F) + g
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
Cost
(aftertax) Weights
Weighted
Cost
Debt (Kd)………………………..
7.26%
50%
3.63%
Appendix
11A-1. Assume that Rf = 5 percent and Km = 10.5 percent. Compute Kj for the following betas
using Formula 11A-2.
a. 0.6
b. 1.3
c. 1.9
11A-1 Solution:
a. Kj= Rf + β (Km – Rf)
= 5% + .6 (10.5% – 5%)
b. Kj= 5% + 1.3 (10.5% – 5%)
c. Kj= 5% + 1.9 (10.5% – 5%)
11A-2. Assume that Rf = 6 percent and the market risk premium (Km – Rf) is 7.0 percent.
Compute Kj for the following betas using Formula 11A-2.
a. 0.6
b. 1.3
c. 1.9
11A-2. Solution:
a. Kj = 6% + .6 (7%)
b. Kj= 6% + 1.3 (7%)
c. Kj= 6% + 1.9 (7%)