Chapter 5

# Chapter 5 - McGill Faculty of Engineering MIME 310...

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1 McGill Faculty of Engineering MIME 310 Engineering Economy Tutorials Chapter 5. Sources of Funds and Cost of Capital

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2 McGill Faculty of Engineering MIME 310 Engineering Economy Tutorials 5.1 Mr Brown, one of the directors of a sewage company, urges that more debt be used to reduce the firm's cost of capital. He recommends that 40 % bonds and 35 % common equity be used instead of the current mixture of 10 % and 65 %, respectively. The firm's current capital structure is: i) What is the firm's existing cost of capital? ii) If all other factors remain the same, what would be the firm's cost of capital under Brown's recommendations? iii) Ms Smith argues that other factors would not remain the same under Brown's recommendations. The greater risk resulting from the higher financial leverage would require a bond yield of 8 % (instead of 6.4 %). Furthermore, the common shareholders would pay less for the shares because of the more uncertain earnings per share. Thus, the earnings to price ratio would rise from 8 to 12 percent. Under these circumstances, what would be the firm's cost of capital? Source Proportion (%) Before-tax Cost (%) After-tax Cost (%) Notes payable 5 5.00 2.50 Bonds 10 6.40 3.20 Preferred stock 20 7.45 7.45 Common equity 65 8.00 8.00 TOTAL 100
3 McGill Faculty of Engineering MIME 310 Engineering Economy Tutorials i) Existing cost of capital WACC = 2.5 (0.05) + 3.2 (0.10) + 7.45 (0.20) + 8.0 (0.65) = 7.135 L 7.1 % ii) According to Brown’s recommendations WACC = 2.5 (0.05) + 3.2 (0.40) + 7.45 (0.20) + 8.0 (0.35) = 5.695 L 5.7 % iii) According to Smith’s argument WACC = 2.5 (0.05) + 4.0 1 (0.40) + 7.45 (0.20) + 12.0 2 (0.35) = 7.415 L 7.4 % 1 The bonds now have a yield of 6.4 % (the before-tax cost). If the after-tax cost is 3.2%, then the tax rate is 50 %. Therefore, the required higher yield of 8% would result in an after-tax cost of 4 %. 2 The earnings to price ratio is an estimate of the existing cost of common equity. The higher ratio represents a higher cost of common equity (12 %).

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Chapter 5 - McGill Faculty of Engineering MIME 310...

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