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c. Rate of return, r1:
−
=+
r
1
401,155$000,675$
8
)r1(
1
d.
10
12
14
Project 4
12%
Project 5
11%
e. From the above graph, we conclude that Ezzell’s management should undertake Projects 1, 2,
f. The solution implicitly assumes (1) that all of the projects are equally risky and (2) that these
g. If the payout ratio were lowered to zero, this would shift the equity break point to the right, from
$1,818,182, to $4,545,455. This shift would have changed the decision—Project 4 would now
12–30 Integrative Problem
16
%
500
1,000
1,500
2,000
2,500
3,000
3,500
Capital Expenditure/Financing
($ thousands)
Project 3
14%
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a. (1) The WACC is used primarily for making long-term capital investment decisions—that is, for
capital budgeting. Thus, the WACC should include the types of capital used to pay for long-
(2) Stockholders are concerned primarily with those corporate cash flows that are available for
(3) In financial management, the cost of capital is used primarily to make decisions that involve
b. Coleman’s 12 percent bond with 15 years to maturity currently is selling for $1,153.72. Thus, its
yield to maturity is 10 percent:
c. (1) Because the preferred issue is perpetual, its cost is estimated as follows:
9.0% = 0.09 =
$2.00 – $113.10
0.1($100)
=
NP
D
= r ps
ps
Note that (1) flotation costs for preferred are significant, so they are included here, (2)
because preferred dividends are not deductible to the issuer, there is no need for a tax
adjustment, and (3) we could have estimated the effective annual cost of the preferred, but
as in the case of debt, the simple cost is generally used.
(2) Corporate investors own most preferred stock, because 70 percent of preferred dividends
0 1 2 3 29 30
…
-1,153.70 60 60 60 60 60
1,000
rd = ?
Principles of Finance 5e Chapter 12
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d. (1) Coleman’s earnings can either be retained and reinvested in the business or paid out as
dividends. If earnings are retained, Coleman’s shareholders forego the opportunity to
(2) The CAPM estimate for Coleman’s cost of retained earnings is 14.2 percent:
e. Because Coleman is a constant growth stock, the constant growth model can be used:
50$
$50
P
P
0
0
f. The bond-yield-plus-risk-premium estimate is 14 percent:
g. The following table summarizes the rs estimates:
Method Estimate
CAPM 14.2%
h. The DCF method produced an estimate for the cost of retained earnings of rs = 13.8% (see the
computations given earlier). However, flotation costs of F = 15% must be incurred when new
common stock is sold, and that increases the cost of equity to 15.4%:
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Thus, flotation costs increase the cost of equity by 1.6 percentage points for up to $300,000 of
new common stock:
Flotation adjustment1 = 15.4% – 13.8% = 1.6%.
i. The company is raising money in order to make an investment. The money has a cost, and this
j. (1) Coleman’s WACC is 11.1 percent when retained earnings are used as the equity
component (at 14 percent):
Up to $300,000 of equity as RE at rs = 14%:
Capital Structure Component
Weights x costs = WACC
0.3 6.0% 1.8%
(2) When up to $300,000 of new common stock is sold, the WACC increases from 11.1
percent to WACC2 = 12.1 percent:
Principles of Finance 5e Chapter 12
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Capital Structure Component
Weights x costs = WACC
0.3 6.0% 1.8%
(3) When more than $300,000 of new common stock is sold, the WACC increases to 12.8
percent:
k. (1) The dollar amount of total new capital at which Coleman uses up its retained earnings and
must resort to selling new common stock will consist of the retained earnings plus debt and
preferred supported by the retained earnings, and the point is called the retained earnings
break point:
$500,000 =
0.60
$300,000
equity of proportion Target
earnings retained of ollarsD
BPRE ==
(2)
strucure capital the in capital of type this of roportionP
type given a of capital cost lower of amount otalT
=
intoP
reakB
(3) A marginal cost of capital (MCC) schedule is simply a plot of the firm’s WACC versus
dollars of new capital raised. Here is Coleman’s MCC schedule:
Chapter 12 Principles of Finance 6e
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20
15
10
500 1,000 1,500 2,000
WACC3 = 12.8%
WACC2 = 12.1%
WACC2 = 11.1%
MCC
Percent
New Capital
($ thousands)
l. (1) The IOS schedule is a plot of the projects being considered by cost and in descending
order of IRR. Note that Coleman actually faces two IOS schedules—one with Projects A, B,
and C, and another with Projects A, B*, and C.
20
15
10
500 1,000 1,500 2,000
A = 17%
B = 16%
B’ = 15%
C = 11.5%
WACC3 = 12.8%
WACC2 = 12.1%
WACC2 = 11.1%
MCC
IOS
1,200
Optimal Capital
Budget
Percent
New Capital
($ Thousands)
Principles of Finance 5e Chapter 12
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(3) As more and more new capital is required in any year, Coleman’s WACC would eventually
begin to rise above 12.8 percent. The company would have to find new buyers for its debt,
(3) In this situation, the MCC curve would cut through Projects B and B*, meaning that those
m. If Coleman could only raise $200,000 of debt at a 10 percent cost and the remaining debt
The WACCs at these intervals would be:
A. Between $1 and $500,000: WACC1 = 11.1%. (just as before.)
B. Between $500,000 and $666,667: WACC2 = 12.1%. (just as before.)
12-31 Computer-Related Problem
a. Under this scenario, the MCC schedule has moved down because all of the WACCs have
Chapter 12 Principles of Finance 6e
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INPUT DATA: KEY OUTPUT:
Debt ratio: 65.00% Ret. earnings break 2,857,143
Earnings: $2,500,000 1st debt break 769,231
Accepted
Beginning of Projects Project
New debt cost: Range rd (non-zero) IRR Cost
0 10.00% 1 16% 675,000
MODEL-GENERATED DATA:
Breaks in the MCC schedule:
Cost of financing below first break:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between first and second breaks:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between second and third breaks:
After-tax Weighted
Component Weight Cost Cost
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Cost of financing above third break:
After-tax Weighted
Component Weight Cost Cost
Capital Cost:
Range of financing Capital cost
1 9.7%
769,231 9.7%
Optimal capital budget:
Project ROR Project
Number/rank Cost
1 16% 675,000
b. (1) Tax rate = 20%
INPUT DATA: KEY OUTPUT:
Debt ratio: 65.00% Ret. earnings break 2,857,143
Earnings: $2,500,000 1st debt break 769,231
Accepted
Beginning of Projects Project
New debt cost: Range rd (non-zero) IRR Cost
Number/rank
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MODEL-GENERATED DATA:
Breaks in the MCC schedule:
Cost of financing below first break:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between first and second breaks:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between second and third breaks:
After-tax Weighted
Component Weight Cost Cost
Cost of financing above third break:
After-tax Weighted
Component Weight Cost Cost
Capital Cost:
Range of financing Capital cost
1 11.0%
769,231 11.0%
Principles of Finance 5e Chapter 12
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Optimal capital budget:
Project ROR Project
Number/rank Cost
1 16% 675,000
b. (1) Tax rate = 0%
INPUT DATA: KEY OUTPUT:
Debt ratio: 65.00% Ret. earnings break 2,857,143
Accepted
Beginning of Projects Project
New debt cost: Range rd (non-zero) IRR Cost
0 10.00% 1 16% 675,000
MODEL-GENERATED DATA:
Breaks in the MCC schedule:
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Cost of financing below first break:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between first and second breaks:
After-tax Weighted
Component Weight Cost Cost
Cost of financing between second and third breaks:
After-tax Weighted
Component Weight Cost Cost
Cost of financing above third break:
After-tax Weighted
Component Weight Cost Cost
Capital Cost:
Range of financing Capital cost
1 12.3%
769,231 12.3%
Optimal capital budget:
Project ROR Project
Number/rank Cost
1 16% 675,000
Principles of Finance 5e Chapter 12
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ETHICAL DILEMMA
How Much Should You Pay to Be “Green”?
Ethical dilemma:
SS is evaluating a project that might help the firm to increase its presence in the “green” industry by
propelling the company into the leadership role in the country’s quest to clean up and protect the
environment. Although Tracey is not evaluating the project’s acceptability, it is her responsibility to
establish the hurdle rate, or weighted average cost of capital (WACC), that is used by those who
conduct capital budgeting analyses. Tracey, who is a compassionate environmentalist, would like to see
SS invest in the project. But, Manual, who works in the capital budgeting department, has told Tracey
that preliminary analysis of the project suggests that its internal rate of return (IRR) is less than the
firm’s WACC, which would mean that the project is not an acceptable investment. Because Tracey feels
the company should purchase the project, she is considering changing the method that she currently
uses to compute the firm’s WACC. If she makes the change, the hurdle rate used to evaluate the
“green” project will be lower than it is currently, and thus the project might turn out to be acceptable.
However, if SS bases its decision on a hurdle rate that is too low and invests a substantial amount in the
project, in the future it might discover that the project actually should have been rejected. It is possible
that this discovery comes too late for the firm to correct its mistake, in which case the firm might find
itself in serious financial trouble.
Discussion questions:
• Is there an ethical problem? If so, what is it?
The question here is whether Tracey should change the weights that she currently uses to compute
• Is it appropriate for Tracey to change the hurdle rate used to evaluate capital budgeting projects?
Maybe. If Tracey can justify using book values rather than market values to weight the component costs
of capital, then it seems that she is making a rational, justifiable change. In fact, the change should be
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• What would you do if you were Tracey?
Perhaps the best solution is to compute the firm’s WACC using both book values and market values to
determine the weights for component costs of capital. Before changing the methods that the firm
currently uses for the WACC computation, Tracey should get approval. If she can show that using book
References:
The following articles might be assigned for background material:
Pete Engardio, “Beyond the Green Corporation,” BusinessWeek, January 29, 2007, pp. 50–64.
John Carey, “Hugging the Tree-Huggers—Why So Many Companies are Suddenly Linking Up with ECO
Groups. Hint: Smart Business,” BusinessWeek, March 12, 2007, pp. 66-68.
Ian Ayes and Barry Nalebuff, “Environmental Atonement: Why Not,” Forbes, December 25, 2006, p. 134.
Emily Thornton, “Who Says It’s Not Easy Being Green,” BusinessWeek, December 25, 2006, p. 76.