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Department
Sociology
Course
SOC 202
Professor
Louis Pike
Semester
Fall

Description
CHAPTER14 COST OF CAPITAL Learning Objectives LO1 How to determine a firm’s cost of equity capital. LO2 How to determine a firm’s cost of debt. LO3 How to determine a firm’s overall cost of capital. LO4 How to correctly include flotation costs in capital budgeting projects. LO5 Some of the pitfalls associated with a firm’s overall cost of capital and what to do about them. Answers to Concepts Review and Critical Thinking Questions 1. (LO3) It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created. 2. (LO3) Book values for debt are likely to be much closer to market values than are equity book values. 3. (LO5) No. The cost of capital depends on the risk of the project, not the source of the money. 4. (LO3) Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs. 5. (LO1) The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1) the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm does pay dividends, the DCF model requires a constant dividend growth rate forever; (3) the estimated cost of equity from this method is very sensitive to changes in g, which is a very uncertain parameter; and (4) the model does not explicitly consider risk, although risk is implicitly considered to the extent that the market has impounded the relevant risk of the stock into its market price. While the share price and most recent dividend can be observed in the market, the dividend growth rate must be estimated. Two common methods of estimating g are to use analysts’ earnings and payout forecasts or to determine some appropriate average historical g from the firm’s available data. 6. (LO1) Two primary advantages of the SML approach are that the model explicitly incorporates the relevant risk of the stock and the method is more widely applicable than is the dividend discount model model, since the SML doesn’t make any assumptions about the firm’s dividends. The primary disadvantages of the SML method are (1) three parameters (the risk-free rate, the expected return on the market, and beta) must be estimated, and (2) the method essentially uses historical information to estimate these parameters. The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence, observable; the market risk premium is usually estimated from historical risk premiums and, hence, is not observable. The stock beta, which is unobservable, is usually estimated either by determining some average historical beta from the firm and the market’s return data, or by using beta estimates provided by analysts and investment firms. 7. (LO2) The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its cost of debt. If the debt is privately-placed, the firm could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the firm’s private debt is rated), or (3) consulting analysts and investment bankers. Even if the debt is publicly traded, an additional complication is when the firm has more than one issue outstanding; these issues rarely have the same yield because no two issues are ever completely homogeneous. 14-1 8. (LO5) a. This only considers the dividend yield component of the required return on equity. b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes. c. Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm’s assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt. 9. (LO5) R Sup= .12 + .75(.08) = .1800 or 18.00% Both should proceed. The appropriate discount rate does not depend on which company is investing; it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play. Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of $1 million regardless of who takes it. 10. (LO5) If the different operating divisions were in much different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market’s valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division. 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 1. (LO1) With the information given, we can find the cost of equity using the dividend growth model. Using this model, the cost of equity is: RE= [$2.40(1.055)/$52] + .055 = .1037 or 10.37% 2. (LO1) Here we have information to calculate the cost of equity using the CAPM. The cost of equity is: R = .053 + 1.05(.12 – .053) = .1234 or 12.34% E 3. (LO1) We have the information available to calculate the cost of equity using the CAPM and the dividend growth model. Using the CAPM, we find: RE= .05 + 0.85(.08) = .1180 or 11.80% And using the dividend growth model, the cost of equity is RE= [$1.60(1.06)/$37] + .06 = .1058 or 10.58% Both estimates of the cost of equity seem reasonable. If we remember the historical return on large capitalization stocks, the estimate from the CAPM model is about two percent higher than average, and the estimate from the dividend growth model is about one percent higher than the historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we will use the average of the two, so: RE= (.1180 + .1058)/2 = .1119 or 11.19% 14-2 4. (LO1) To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was: g1= ($1.12 – 1.05)/$1.05 = .0667 or 6.67% g2= ($1.19 – 1.12)/$1.12 = .0625 or 6.25% g3= ($1.30 – 1.19)/$1.19 = .0924 or 9.24% g4= ($1.43 – 1.30)/$1.30 = .1000 or 10.00% So, the average arithmetic growth rate in dividends was: g = (.0667 + .0625 + .0924 + .1000)/4 = .0804 or 8.04% Using this growth rate in the dividend growth model, we find the cost of equity is: R E [$1.43(1.0804)/$45.00] + .0804 = .1147 or 11.47% Calculating the geometric growth rate in dividends, we find: 4 $1.43 = $1.05(1 + g) g = .0803 or 8.03% The cost of equity using the geometric dividend growth rate is: R E [$1.43(1.0803)/$45.00] + .0803 = .1146 or 11.46% 5. (LO1) The cost of preferred stock is the dividend payment divided by the price, so: R P $6/$96 = .0625 or 6.25% 6. (LO2) The pretax cost of debt is the YTM of the company’s bonds, so: P0= $1,070 = $35(PVIFA R%,30 + $1,000(PVIF R%,30 R = 3.137% YTM = 2 × 3.137% = 6.27% And the aftertax cost of debt is: R D .0627(1 – .35) = .0408 or 4.08% 7. (LO2) a. The pretax cost of debt is the YTM of the company’s bonds, so: P = $950 = $40(PVIFA ) + $1,000(PVIF ) 0 R%,46 R%,46 R = 4.249% YTM = 2 × 4.249% = 8.50% b. The aftertax cost of debt is: R D .0850(1 – .35) = .0552 or 5.52% c. The after-tax rate is more relevant because that is the actual cost to the company. 14-3 8. (LO2) The book value of debt is the total par value of all outstanding debt, so: BV =D$80,000,000 + 35,000,000 = $115,000,000 To find the market value of debt, we find the price of the bonds and multiply by the number of bonds. Alternatively, we can multiply the price quote of the bond times the par value of the bonds. Doing so, we find: MV =D.95($80,000,000) + .61($35,000,000) MV =D$76,000,000 + 21,350,000 MV =D$97,350,000 The YTM of the zero coupon bonds is: P Z $610 = $1,000(PVIF R%,14 R = 3.594% YTM = 2 × 3.594% = 7.19% So, the aftertax cost of the zero coupon bonds is: R Z .0719(1 – .35) = .0467 or 4.67% The aftertax cost of debt for the company is the weighted average of the aftertax cost of debt for all outstanding bond issues. We need to use the market value weights of the bonds. The total aftertax cost of debt for the company is: R D .0552($76/$97.35) + .0467($21.35/$97.35) = .0534 or 5.34% 9. (LO3) a. Using the equation to calculate the WACC, we find: WACC = .60(.14) + .05(.06) + .35(.08)(1 – .35) = .1052 or 10.52% b. Since interest is tax deductible and dividends are not, we must look at the after-tax cost of debt, which is: .08(1 – .35) = .0520 or 5.20% Hence, on an after-tax basis, debt is cheaper than the preferred stock. 10. (LO3) Here we need to use the debt-equity ratio to calculate the WACC. Doing so, we find: WACC = .15(1/1.65) + .09(.65/1.65)(1 – .35) = .1140 or 11.40% 11. (LO3) Here we have the WACC and need to find the debt-equity ratio of the company. Setting up the WACC equation, we find: WACC = .0890 = .12(E/V) + .079(D/V)(1 – .35) Rearranging the equation, we find: .0890(V/E) = .12 + .079(.65)(D/E) Now we must realize that the V/E is just the equity multiplier, which is equal to: V/E = 1 + D/E .0890(D/E + 1) = .12 + .05135(D/E) 14-4 Now we can solve for D/E as: .06765(D/E) = .031 D/E = .8234 12. (LO3) 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: BV =E11,000,000($6) = $66,000,000 BV = $70,000,000 + 55,000,000 = $125,000,000 D So, the total value of the company is: V = $66,000,000 + 125,000,000 = $191,000,000 And the book value weights of equity and debt are: E/V = $66,000,000/$191,000,000 = .3455 D/V = 1 – E/V = .6545 b. The market value of equity is the share price times the number of shares, so: MV = 11,000,000($68) = $748,000,000 E Using the relationship that the total market value of debt is the price quote times the par value of the bond, we find the market value of debt is: MV = D93($70,000,000) + 1.04($55,000,000) = $122,300,000 This makes the total market value of the company: V = $748,000,000 + 122,300,000 = $870,300,000 And the market value weights of equity and debt are: E/V = $748,000,000/$870,300,000 = .8595 D/V = 1 – E/V = .1405 c. The market value weights are more relevant. 13. (LO3) First, we will find the cost of equity for the company. The information provided allows us to solve for the cost of equity using the dividend growth model, so: RE= [$4.10(1.06)/$68] + .06 = .1239 or 12.39% Next, we need to find the YTM on both bond issues. Doing so, we find: P = $930 = $35(PVIFA ) + $1,000(PVIF ) 1 R%,42 R%,42 R = 3.838% YTM = 3.838% × 2 = 7.68% P2= $1,040 = $40(PVIFA R%,12 + $1,000(PVIF R%,12 14-5 R = 3.584% YTM = 3.584% × 2 = 7.17% To find the weighted average aftertax cost of debt, we need the weight of each bond as a percentage of the total debt. We find: w D1.93($70,000,000)/$122,300,000 = .5323 w D21.04($55,000,000)/$122,300,000 = .4677 Now we can multiply the weighted average cost of debt times one minus the tax rate to find the weighted average aftertax
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