MIME 310 - Solutions Chapter 5

# MIME 310 - Solutions Chapter 5 - MIME 310 ENGINEERING...

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3 1 0 E N G I N E E R I N G E C O N O M Y SOLUTIONS TO PROBLEM SET #5 – SOURCES OF FUNDS AND THE COST OF CAPITAL 1. The company's current cost of capital, as opposed to that associated with issuing addi- tional funds, is determined by omitting the issuing expenses that would be incurred to raise such funds. Cost of bonds Because the remaining life of the bonds is less than 10 years, the exact method is used. The current market price of a bond (the price that an investor is willing to pay), rather than the net proceeds resulting from a new issue, is used to determine the current cost of debt (K d ). Expressed on a quarterly basis, the cost of debt is the discount rate that satisfies the following relationship: 95 = 2 (P/A,i,28) + 100 (P/F,i,28) Solving by trial and error, we have: For i=2.0%: 2 (21.2813) + 100 (0.5744) = 100.00 For i=2.5%: 2 (19.9649) + 100 (0.5009) = 90.02 By linear interpolation: K d = 2 + 0.5 [(100 - 95) / (100.00 - 90.02 )] = 2.25% per quarter The use of a financial calculator yields a result of 2.2424%. Expressed as an effective annual rate, the cost of debt is: K d = (1 + 0.022424) 4 - 1 = 0.0928 or 9.28% Cost of preferred stock The current market price of a share, rather than the net proceeds resulting from a new issue, is used to determine the current cost of preferred equity (K p ). K p = 7 / 100 = 0.07 or 7% Cost of common stock The current market price of a share, rather than the net proceeds resulting from a new issue, is used to determine the

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MIME 310 - Solutions Chapter 5 - MIME 310 ENGINEERING...

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