Unformatted text preview: Cost of preferred stock: Nd (1 T) [Eq. 11.2] Dp
Np kp [Eq. 11.3] Cost of common stock equity:
valuation model: D1
P0 ks Using CAPM: ks RF [b Cost of retained earnings: kr Cost of new issues of common stock: kn g
(km [Eq. 11.5]
RF)] [Eq. 11.6] ks
Nn [Eq. 11.7]
g [Eq. 11.8] Weighted average cost of capital (WACC):
Break point: (wi ki) (wp
wj (ws kr or n) [Eq. 11.9]
[Eq. 11.10] CHAPTER 11 The Cost of Capital 493 SELF-TEST PROBLEM (Solution in Appendix B)
LG2 LG3 LG4 LG5 LG6 ST 11–1 Specific costs, WACC, WMCC, and IOS Humble Manufacturing is interested
in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has gathered the following data:
Debt The firm can raise an unlimited amount of debt by selling $1,000-parvalue, 10% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond must
be given. The firm must also pay flotation costs of $20 per bond.
Preferred stock The firm can sell 11% (annual dividend) preferred stock at its
$100-per-share par value. The cost of issuing and selling the preferred stock is
expected to be $4 per share. An unlimited amount of preferred stock can be sold
under these terms.
Common stock The firm’s common stock is currently selling for $80 per share.
The firm expects to pay cash dividends of $6 per share next year. The firm’s dividends have been growing at an annual rate of 6%, and this rate is expected to
continue in the future. The stock will have to be underpriced by $4 per share,
and flotation costs are expected to amount to $4 per share. The firm can sell an
unlimited amount of new common stock under these terms.
Retained earnings The firm expects to have $225,000 of retained earnings
available in the coming year. Once these retained earnings are exhausted, the
firm will use new common stock as the form of common stock equity
a. Calculate the specific cost of each source of financing. (Round to the nearest
b. The firm uses the weights shown in the following table, which are based on
target capital structure proportions, to calculate its weighted average cost of
capital. (Round to the nearest 0.1%.)
Source of capital Weight Long-term debt 40% Preferred stock 15 Common stock equity
100% (1) Calculate the single break point associated with the firm’s financial situation. (Hint: This point results from the exhaustion of the firm’s retained
(2) Calculate the weighted average cost of capital associated with total new
financing below the break point calculated in part (1).
(3) Calculate the weighted average cost of capital associated with total new
financing above the break point calculated in part (1). 494 PART 4 Long-Term Financial Decisions c. Using the results of part b along with the information shown in the following
table on the available investment opportunities, draw the firm’s weighted
marginal cost of capital (WMCC) schedule and investment opportunities
schedule (IOS) on the same set of axes (total new financing or investment on
the x axis and weighted average cost of capital and IRR on the y axis). Investment
rate of return
investment A 11.2% $100,000 B 9.7 500,000 C 12.9 150,000 D 16.5 200,000 E 11.8 450,000 F 10.1 600,000 G 10.5 300,000 d. Which, if any, of the available investments do you recommend that the firm
accept? Explain your answer. How much total new financing is required? PROBLEMS
LG1 11–1 Concept of cost of capital Wren Manufacturing is in the process of analyzing
its investment decision-making procedures. The two projects evaluated by the
firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis, using the IRR decision technique, and the resulting decision actions are summarized in the following table.
Basic variables Project 263 Project 264 Cost $64,000 $58,000 Life 15 years 15 years IRR 8% 15% Least-cost financing
Source Debt Equity Cost (after-tax) 7% 16% Decision
Action Accept Reason 8% IRR Reject
7% cost 15% IRR 16% cost a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’
b. If the firm maintains a capital structure containing 40% debt and 60%
equity, find its weighted average cost using the data in the table. CHAPTER 11 The Cost of Capital 495 c. Had the firm used the weighted average cost calculated in part b, what actions
would have been indicated relative to projects 263 and 264?
d. Compare and contrast the firm’s actions with your findings in part c. Which
decision method seems more appropriate? Explain why.
LG2 11–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year,
$1,000-par-value bonds paying annual interest at a 12% coupon rate. As a
result of current interest rates, the bonds can be sold for $1,010 each; flotation
costs of $30...
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