Chapter 11

The Cost of Capital

Solutions to End-Of-Chapter Problems

11-1 rd(1 – T) = 0.12(0.65) = 7.80%.

11-2 Pp = $47.50; Dp = $3.80; rp = ?

Dp $3.80
rp = = = 8%.
Pp $47.50

11-3 40% Debt; 60% Common equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?

WACC = (wd)(rd)(1 – T) + (wc)(rs)

0.0996 = (0.4)(0.09)(1 – 0.4) + (0.6)rs
0.0996 = 0.0216 + 0.6rs
0.078 = 0.6rs
rs = 13%.

11-4 P0 = $30; D1 = $3.00; g = 5%; rs = ?

D1 $3.00
a. rs = +g= + 0.05 = 15%.
P0 $30.00

b. F = 10%; re = ?

D1 $3.00
re = +g = + 0.05
P0 (1  F) $30(1  0.10)
$3.00
= + 0.05 = 16.11%.
$27.00

11-5 Projects A, B, C, D, and E would be accepted since each project’s return is greater than the firm’s
WACC.

D1 $2.14
11-6 a. rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23

b. rs = rRF + (rM – rRF)b

= 9% + (13% – 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

d. Since you have equal confidence in the inputs used for the three approaches, an average of
the three methodologies probably would be warranted.

Chapter 11: The Cost of Capital Integrated Case 1

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 16.3%  15.4%  16%
rs = = 15.9%.
3

D1
11-7 a. rs = +g
P0
$3.18
= + 0.06
$36
= 14.83%.

b. F = ($36.00 – $32.40)/$36.00 = $3.60/$36.00 = 10%.

c. re = D1/[P0(1 – F)] + g = $3.18/$32.40 + 6% = 9.81% + 6% = 15.81%.

11-8 Debt = 40%, Common equity = 60%.

P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%.

D1 $2.14
rs = +g= + 7% = 16.51%.
P0 $22.50

WACC = (0.4)(0.12)(1 – 0.4) + (0.6)(0.1651)

= 0.0288 + 0.0991 = 12.79%.

11-9 BV LTD = MV LTD = $1,152; P0 = $4.00; Shares outstanding = 576; T = 40%

MV Equity = $4.00 × 576 shares = $2,304.

Capital Sources Market Value Market Value Weight

Long-term debt $1,152 $1,152/$3,456 = 33.33%
Common Equity 2,304 $2,304/$3,456 = 66.67%
Total capital $3,456 100.00%

WACC = wdrd(1 – T) + wcrs

= 0.3333(0.13)(0.6) + 0.6667(0.16)
= 0.0260 + 0.1067 = 13.27%.

11-10 If the investment requires $5.9 million, that means that it requires $3.54 million (60%) of
common equity and $2.36 million (40%) of debt. In this scenario, the firm would exhaust its $2
million of retained earnings and be forced to raise new stock at a cost of 15%. Needing $2.36
million in debt, the firm could get by raising debt at only 10%. Therefore, its weighted average
cost of capital is: WACC = 0.4(10%)(1 – 0.4) + 0.6(15%) = 11.4%.

11-11 rs = D1/P0 + g
= $2(1.07)/$24.75 + 7%
= 8.65% + 7% = 15.65%.

WACC = wd(rd)(1 – T) + wc(rs); wc = 1 – wd.

13.95% = wd(11%)(1 – 0.35) + (1 – wd)(15.65%)

2 Integrated Case Chapter 11: The Cost of Capital
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 0.1395 = 0.0715wd + 0.1565 – 0.1565wd
-0.017 = -0.085wd
wd = 0.20 = 20%.

11-12 a. rd = 10%, rd(1 – T) = 10%(0.6) = 6%.

wd = 45%; D0 = $2; g = 4%; P0 = $20; T = 40%.

Project A: Rate of return = 13%.

Project B: Rate of return = 10%.

rs = $2(1.04)/$20 + 4% = 14.40%.

b. WACC = 0.45(6%) + 0.55(14.40%) = 10.62%.

c. Since the firm’s WACC is 10.62% and each of the projects is equally risky and as risky as the
firm’s other assets, MEC should accept Project A. Its rate of return is greater than the firm’s
WACC. Project B should not be accepted, since its rate of return is less than MEC’s WACC.

11-13 If the firm's dividend yield is 5% and its stock price is $46.75, the next expected annual dividend
can be calculated.

Dividend yield= D1/P0

5% = D1/$46.75
D1 = $2.3375.

Next, the firm's cost of new common stock can be determined from the DCF approach for the
cost of equity.

re = D1/[P0(1 – F)] + g
= $2.3375/[$46.75(1 – 0.05)] + 0.12
= 17.26%.

$11
11-14 rp = = 11.94%.
$92.15

11-15 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.

WACC = wd(rd)(1 – T) + wc(rs)

13.0% = 0.4(10%)(1 – 0.4) + 0.6(rs)
10.6% = 0.6rs
rs = 0.17667 or 17.67%.

From the cost of common equity, the expected growth rate can now be determined.

rs = D1/P0 + g
0.17667 = $3/$35 + g

Chapter 11: The Cost of Capital Integrated Case 3

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 g = 0.090952  9.10%.

b. From the formula for the long-run growth rate:

g = (1 – Div. payout ratio)  ROE
= (1 – Div. payout ratio)  (NI/Equity)
0.090952 = (1 – Div. payout ratio)  ($1,100 million/$6,000 million)
0.090952 = (1 – Div. payout ratio)  0.1833333
0.496104 = (1 – Div. payout ratio)
Div. payout ratio = 0.503896 or 50.39%.

11-16 a. With a financial calculator, input N = 5, PV = -4.42, PMT = 0, FV = 6.50, and then solve for
I/YR = g = 8.02%  8%.

b. D1 = D0(1 + g) = $2.60(1.08) = $2.81.

c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.

D1
11-17 a. rs = +g
P0
$3.60
0.09 = +g
$60.00
0.09 = 0.06 + g
g = 3%.

b. Current EPS $5.400 Alternatively:

Less: Dividends per share 3.600 EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.
Retained earnings per share $1.800
Rate of return  0.090
Increase in EPS $0.162
Plus: Current EPS 5.400
Next year’s EPS $5.562

11-18 a. rd(1 – T) = 0.10(1 – 0.3) = 7%.

rp = $5/$49 = 10.2%.
rs = $3.50/$36 + 6% = 15.72%.

b. WACC: After-Tax Weighted

Component Weight  Cost = Cost
Debt 0.15 7.00% 1.05%
Preferred stock 0.10 10.20 1.02
Common stock 0.75 15.72 11.79
WACC = 13.86%

c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

4 Integrated Case Chapter 11: The Cost of Capital

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11-19 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 5 million 11.5 12
C 3 million 9.5 8
D 2 million 9.0 10
E 6 million 12.5 12
F 5 million 12.5 10
G 6 million 7.0 8
H 3 million 11.5 8

Therefore, Ziege should accept projects A, C, E, F, and H.

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
$21 million, so naturally not all these projects may be accepted. Looking at the excess
return created by the projects (rate of return minus the cost of capital), we see that the
excess returns for Projects A, C, E, F, and H are 2%, 1.5%, 0.5%, 2.5%, and 3.5%. The
firm should accept the projects which provide the greatest excess returns. By that rationale,
the first project to be eliminated from consideration is Project E. This brings the total
investment required down to $15 million, therefore one more project must be eliminated.
The next lowest excess return is Project C. Therefore, Ziege's optimal capital budget
consists of Projects A, F, and H, and it amounts to $12 million.

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).

Required Rate of Cost of

Project Investment Return Capital
C $3 million 9.5% 8% + 1% = 9%
E 6 million 12.5 12% + 1% = 13%

If new capital must be issued, Project E ceases to be an acceptable project. On the other
hand, Project C's expected rate of return still exceeds the risk-adjusted cost of capital even
after raising additional capital. Hence, Ziege's new capital budget should consist of Projects
A, C, F, and H and requires $15 million of capital, so an additional $2 million must be raised
above the initial $13 million constraint.

11-20 a. After-tax cost of new debt: rd(1 – T) = 0.09(1 – 0.4) = 5.4%.

Cost of common equity: Calculate g as follows:

With a financial calculator, input N = 9, PV = -3.90, PMT = 0, FV = 7.80, and then solve for
I/YR = g = 8.01%  8%.

D1 (0.55)($ 7.80) $4.29

rs = +g= + 0.08 = + 0.08 = 0.146 = 14.6%.
P0 $65.00 $65.00

Chapter 11: The Cost of Capital Integrated Case 5

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 b. WACC calculation:
Target After-Tax Weighted
Component Weight  Cost = Cost
Debt 0.40 5.4% 2.16%
Common equity (RE) 0.60 14.6 8.76
WACC = 10.92%

6 Integrated Case Chapter 11: The Cost of Capital

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.