CHAPTER 19

Ifweignoreissue costs waccrd1tcdvreev

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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: Stock issue: (0.050 ´ \$1,000,000) = \$50,000 Bond issue: (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’...
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