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CHAPTER 14
COST OF CAPITAL
Answers to Concepts Review and Critical Thinking Questions
1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than
6. Two primary advantages of the SML approach are that the model explicitly incorporates the relevant
CHAPTER 14 - 2
10. If the different operating divisions were in much different risk classes, then separate cost of capital
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
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And using the dividend growth model, the cost of equity is
4. To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase
in dividends each year was:
5. The cost of preferred stock is the dividend payment divided by the price, so:
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7. a. The pretax cost of debt is the YTM of the company’s bonds, so:
8. The book value of debt is the total par value of all outstanding debt, so:
The YTM of the zero coupon bonds is:
9. a. Using the equation to calculate the WACC, we find:
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10. Here we need to use the debt-equity ratio to calculate the WACC. Doing so, we find:
11. Here we have the WACC and need to find the debt-equity ratio of the company. Setting up the WACC
equation, we find:
12. a. The book value of equity is the book value per share times the number of shares, and the book
value of debt is the face value of the company’s debt, so:
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13. First, we will find the cost of equity for the company. The information provided allows us to solve for
14. a. Using the equation to calculate WACC, we find:
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b. Using the equation to calculate WACC, we find:
15. We will begin by finding the market value of each type of financing. We find:
And the total market value of the firm is:
16. a. We will begin by finding the market value of each type of financing. We find:
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So, the market value weights of the company’s financing is:
b. Using the CAPM to consider the projects, we need to calculate the expected return of the project
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b. The weighted average flotation cost is the weighted average of the flotation costs for debt and
equity, so:
19. We first need to find the weighted average flotation cost. Doing so, we find:
Intermediate
20. Using the debt-equity ratio to calculate the WACC, we find:
21. The total cost including flotation costs was:
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Using the equation to calculate the total cost including flotation costs, we get:
22. To find the aftertax cost of debt for the company, we need to find the weighted average of the four
debt issues. We will begin by calculating the market value of each debt issue, which is:
So, the total market value of the company’s debt is:
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23. a. Using the dividend growth model, the cost of equity is:
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Challenge
24. We can use the debt-equity ratio to calculate the weights of equity and debt. The debt of the company
has a weight for long-term debt and a weight for accounts payable. We can use the weight given for
accounts payable to calculate the weight of accounts payable and the weight of long-term debt. The
weight of each will be:
25. We can use the debt-equity ratio to calculate the weights of equity and debt. The weight of debt in the
capital structure is:
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Now we can calculate the weighted average flotation costs for the various percentages of internally
raised equity. To find the portion of equity flotation costs, we can multiply the equity costs by the
percentage of equity raised externally, which is one minus the percentage raised internally. So, if the
company raises all equity externally, the flotation costs are:
If the company uses 60 percent internally generated equity, the flotation cost is:
And the initial cash flow will be:
And the initial cash flow will be:
26. The $4.5 million cost of the land three years ago is a sunk cost and irrelevant; the $5.3 million
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Next we need to find the cost of funds. We have the information available to calculate the cost of
equity using the CAPM, so:
a. The weighted average flotation cost is the sum of the weight of each source of funds in the capital
structure of the company times the flotation costs, so:
This would make the total initial cash flow:
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b. To find the required return on this project, we first need to calculate the WACC for the company.
c. The annual depreciation for the equipment will be:
d. Using the tax shield approach, the OCF for this project is:
e. The accounting breakeven sales figure for this project is:
f. We have calculated all cash flows of the project. We just need to make sure that in Year 5 we
add back the aftertax salvage value and the recovery of the initial NWC. The cash flows for the
project are:
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And the IRR is:
If the initial NWC is assumed to be financed from outside sources, the cash flows are:
