chap012 - Solutions to Chapter 12 The Cost of Capital 1....

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Solutions to Chapter 12 The Cost of Capital 1. The yield to maturity for the bonds (since maturity is now 19 years) is the interest rate (r) that is the solution to the following equation: [$80 × annuity factor(r, 19 years)] + [$1,000/(1 + r) 19 ] = $1,050 Using a financial calculator, enter: n = 19, FV = 1000, PV = (-)1050, PMT = 90, and then compute i = 7.50% Therefore, the after-tax cost of debt is: 7.50% × (1 – 0.35) = 4.88% 2. r = DIV/P 0 = $4/$40 = 0.10 = 10% 3. × + × + - × × = equity preferred C debt r V E r V P ) T 1 ( r V D WACC = [0.3 × 7.50% × (1 – 0.35)] + [0.2 × 10%] + [0.5 × 12.0%] = 9.46% 4. % 75 . 13 1375 . 0 05 . 0 60 $ 05 . 1 5 $ g P ) g 1 ( DIV g P DIV r 0 0 0 1 = = + × = + + = + = 5. The total value of the firm is $80 million. The weights for each security class are as follows: Debt: D/V = 20/80 = 0.250 Preferred: P/V = 10/80 = 0.125 Common: E/V = 50/80 = 0.625 × + × + - × × = equity preferred C debt r V E r V P ) T 1 ( r V D WACC = [0.250 × 6% × (1 – 0.35)] + [0.125 × 8%] + [0.625 × 12.0%] = 9.475% 6. Executive Fruit should use the WACC of Geothermal, not its own WACC, when evaluating an investment in geothermal power production. The risk of the project determines the discount rate, and in this case, Geothermal’s WACC is more reflective of the risk of the project in question. The proper discount rate, therefore, is not 12.3%. It is more likely to be 11.4%. 7. The flotation costs reduce the NPV of the project by $1.2 million. Even so, project NPV is still positive, so the project should be undertaken. 12-1
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8. The rate on Buildwell’s debt is 5 percent. The cost of equity capital is the required rate of return on equity, which can be calculated from the CAPM as follows: 4% + (0.90 × 8%) = 11.2% The weighted average cost of capital, with a tax rate of zero, is: × + - × × = equity C debt r V E ) T 1 ( r V D WACC = [0.30 × 5% × (1 – 0)] + [0.70 × 11.2%] = 9.34% 9. The internal rate of return, which is 12%, exceeds the cost of capital. Therefore, BCCI should accept the project. The present value of the project cash flows is: $100,000 × annuity factor(9.34%, 8 years) = $546,556.08 This is the most BCCI should pay for the project. 10. Security Market Value Explanation Debt $ 5.5 million 1.10 × par value of $5 million Equity $15.0 million $30 per share × 500,000 shares * Total $20.5 million *Number of shares = 000 , 500 share per book value 20 $ book value million 10 $ = × + - × × = equity C debt r V E ) T 1 ( r V D WACC % 42 . 12 % 15 5 . 20 15 ) 40 . 0 1 ( % 9 5 . 20 5 . 5 = × + - × × = 11. Since the firm is all-equity financed: asset beta = equity beta = 0.8 The WACC is the same as the cost of equity, which can be calculated using the
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chap012 - Solutions to Chapter 12 The Cost of Capital 1....

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