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Chapter 10: The Cost of Capital
Learning Objectives
247
Chapter 10
The Cost of Capital
Learning Objectives
After reading this chapter, students should be able to:
◆ Explain why the weighted average cost of capital (WACC) is used in capital budgeting.
◆ Estimate the costs of different capital components—debt, preferred stock, retained earnings, and
common stock.
◆ Combine the different component costs to determine the firm’s WACC.
248
Lecture Suggestions
Chapter 10: The Cost of Capital
Lecture Suggestions
Chapter 10 uses the rate of return concepts covered in previous chapters, along with the concept of the
weighted average cost of capital (WACC), to develop a corporate cost of capital for use in capital
budgeting. We begin with an overview of the WACC using Allied’s capital structure to differentiate
among book value, market value, and target capital structure weights that might be used in calculating
the firm’s WACC. We next explain how to estimate the cost of each capital component, and how to put
the components together to determine the WACC. We go on to discuss factors that affect the WACC and
how to adjust the cost of capital for risk. We conclude the chapter with a discussion on some problems
with cost of capital estimates.
What we cover, and the way we cover it, can be seen by scanning the slides and Integrated Case
solution for Chapter 10, which appears at the end of this chapter’s solutions. For other suggestions
about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct
our classes.
DAYS ON CHAPTER: 3 OF 56 DAYS (50-minute periods)
Chapter 10: The Cost of Capital
Answers and Solutions
249
Answers to End-Of-Chapter Questions
10-1 Probable Effect on
rd(1 – T) rs WACC
a. The corporate tax rate is lowered. + 0 +
10-3 Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common
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Answers and Solutions
Chapter 10: The Cost of Capital
10-4 In general, failing to adjust for differences in risk would lead the firm to accept too many risky
projects and reject too many safe ones. Over time, the firm would become more risky, its WACC
10-5 The cost of retained earnings is lower than the cost of new common equity; therefore, if new
common stock had to be issued then the firm’s WACC would increase.
Chapter 10: The Cost of Capital
Answers and Solutions
251
Solutions to End-Of-Chapter Problems
10-2 Pp = $47.50; Dp = $3.80; rp = ?
10-4 P0 = $30; D1 = $3.00; g = 5%; rs = ?
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Answers and Solutions
Chapter 10: The Cost of Capital
10-7 a. rs =
0
1
P
D
+ g
10-8 Debt = 40%, Common equity = 60%.
10-10 If the investment requires $5.9 million, that means it requires $3.54 million (60%) of common
Chapter 10: The Cost of Capital
Answers and Solutions
253
10-12 a. rd = 10%, rd(1 – T) = 10%(0.6) = 6%.
10-13 If the firm's dividend yield is 5% and its stock price is $46.75, the next expected annual dividend
can be calculated.
10-15 a. Examining the DCF approach to the cost of retained earnings, the expected growth rate can
be determined from the cost of common equity, price, and expected dividend. However,
first, this problem requires that the formula for WACC be used to determine the cost of
common equity.
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Answers and Solutions
Chapter 10: The Cost of Capital
b. From the formula for the long-run growth rate:
10-17 a. rs =
1
P
D
+ g
Chapter 10: The Cost of Capital
Answers and Solutions
255
10-19 a. If all project decisions are independent, the firm should accept all projects whose returns exceed
their risk-adjusted costs of capital. The appropriate costs of capital are summarized below:
Required Rate of Cost of
Project Investment Return Capital
A $4 million 14.0% 12%
b. With only $13 million to invest in its capital budget, Ziege must choose the best combination
of Projects A, C, E, F, and H. Collectively, the projects would account for an investment of
c. Since Projects A, F, and H are already accepted projects, we must adjust the costs of capital
for the other two value producing projects (C and E).
10-20 a. After-tax cost of new debt: rd(1 – T) = 0.09(1 – 0.4) = 5.4%.
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Answers and Solutions
Chapter 10: The Cost of Capital
b. WACC calculation:
Target After-Tax Weighted
Chapter 10: The Cost of Capital
Comprehensive/Spreadsheet Problem
257
Comprehensive/Spreadsheet Problem
Note to Instructors:
The solution to this problem is not provided to students at the back of their text. Instructors
can access the
Excel
file on the textbook’s website.
10-21 a.
INPUT DATA
Cost of debt
