Unformatted text preview: cost of capital. An adjusted discount rate
does not equal the WACC when it takes into account major changes in expected capital
structure or costs. 13. Note the following:
· The costs of debt and equity are not 8.5% and 19%, respectively. These figures
assume the issue costs are paid every year, not just at issue.
· The fact that Bunsen can finance the entire cost of the project with debt is irrelevant. The cost of capital does not depend on the immediate source of funds; what matters is
the project’s contribution to the firm’s overall borrowing power.
· The project is expected to support debt in perpetuity. The fact that the first debt issue is
for only 20 years is irrelevant. Assume the project has the same business risk as the firm’s other assets. Because it is a
perpetuity, we can use the firm’s weightedaverage cost of capital. If we ignore issue
costs: WACC = [rD ´ (1 TC) ´ (D/V)] + [rE ´ (E/V)] WACC = [0.07 ´ (1 .35) ´ (0.4)] + [0.14 ´ 0.6] = 0.1022 = 10.22% Using this discount rate: The issue costs are:
(0.050 ´ $1,000,000) = $50,000
(0.015 ´ $1,000,000) = $15,000 Debt is clearly less expensive. Project NPV net of issue costs is reduced to: ($272,016 $15,000) = $257,016. However, if debt is used, the firm’s debt ratio will be above the target ratio, and more equity will have to be raised later. If debt financing can be
obtained using retaining earnings, then there are no other issue costs to consider. If stock
will be issued to regain the target debt ratio, an additional issue cost is incurred. A careful estimate of the issue costs attributable to this project would require a comparison
of Bunsen’s financial plan ‘with’ as compared to ‘without’ this project. 14. From the text, Section 19.6, footnote 29, solving for bA, we find that: Using the Security Market Line, we calculate the opportunity cost of capital for
Sphagnum’s assets: rA = rf + bA (rm – rf) = 0.09 + (0.6738 ´ 0.085) = 0.147 = 14.7% Following MM’...
View Full Document