To calculate the aftertax cost of debt, multiply by (1
–
T) as follows:
(1  0.40)
u
9.3594% = 5.6156%

5.62%.
96.
Cost of common equity:
CAPM
Answer: c
Diff: E
N
k
s
= 5% + (6%)1.6 = 14.6%.
97.
WACC
Answer: b
Diff: E
N
WACC = (0.40)(5.6156%) + (0.60)(14.6%) = 11.0062%

11.0%.
Chapter 9  Page 55
WEB APPENDIX
9A
SOLUTIONS
9A1.
Risk and divisional costs of capital
Answer: a
Diff: E
N
The correct answer is statement a.
The composite WACC will be the average
of the two divisional WACCs.
Since there is no debt, the WACC = k
s
.
There
is no cost of equity given, but it can be calculated from the beta, the
riskfree rate, and the market risk premium using CAPM.
The beta of the
entire company is the weighted average of the two divisions’ betas (0.5
u
0.8 + 0.5
u
1.2 = 1.0).
The firm’s cost of equity will be equal to 11% (k
s
= k
RF
+ (RP
M
)b = 6% + 5%
u
1.0 = 11%).
Therefore, the WACC is 11%, and
statement a is correct.
Division B has a higher beta, therefore its cost
of capital will be higher than A’s.
Therefore, statement b is false.
If
both divisions were assigned the same hurdle rate, this rate would reflect
the required return on projects with a beta of 1.0.
Since Division A’s
average projects have a beta of 0.8, they would tend to have a lower
return.
Therefore, fewer of them would meet the hurdle rate of 11%, and
the company would choose too few of them.
Conversely, the company would
choose too many projects in Division B.
Therefore, statement c is false.
9A2.
Risk and project betas
Answer: d
Diff: M
9A3.
SML and capital budgeting
Answer: a
Diff: M
9A4.
Project cost of capital
Answer: c
Diff: E
Calculate the required return, k
s
, and compare to the expected return,
s
k
ˆ
.
s
k
ˆ
= 7%.
k
s
= k
RF
+ (k
M
 k
RF
)b = 7% + (10%  7%)0.5 = 8.5%.
k
s
>
s
k
ˆ
; 8.5% > 7.0%; reject the investment.
9A5.
Project cost of capital
Answer: e
Diff: M
Calculate the beta of the firm, and use to calculate project beta:
k
s
= 0.16
= 0.10 + (0.05)b
Firm
.
b
Firm
= 1.2.
b
Project
= (b
Firm
)1.5. (b
Project
is 50% greater than current b
Firm
)
b
Project
= (1.2)1.5 = 1.8.
Calculate required return on project, kProject, and compare to expected
Chapter 9  Page 56
return:
Project:
k
Project
= 0.10 + (0.05)1.8 = 0.19 = 19%.
Expected return = 0.18 =
18%.
Since the required return is one percentage point greater than the
expected return, the firm should not accept the new project.
WEB APPENDIX
9B
SOLUTIONS
9B1.
Pure play method
Answer: b
Diff: M
9B2.
Corporate WACC for firm with divisions
Answer: c
Diff: E
N
For Division A:
k
A
= k
RF
+ (k
M
–
k
RF
)b
A
k
A
= 5% + (6%)0.8
k
A
= 9.8%.
For Division B:
k
B
= k
RF
+ (k
M
–
k
RF
)b
B
k
B
= 5% + (6%)1.5
k
B
= 14%.
WACC = w
A
k
A
+ w
B
k
B
= (0.50)(0.098) + (0.50)(0.14)
= 0.119, or 11.9%.
9B3.
Pure play method
Answer: b
Diff: M
Calculate the required return, k
s
, and use to calculate the WACC:
k
s
= 10% + 1.38(5%) = 16.9%.
WACC = 0.5(12.0%)(0.6) + 0.5(16.9%) = 12.05%.
Compare expected project return,
Project
k
ˆ
, to WACC:
But
Project
k
ˆ
= 13.0%.
Accept the project since
WACC
k
ˆ
Project
!
:
13.0% > 12.05%.
You've reached the end of your free preview.
Want to read all 56 pages?
 Fall '14
 Corporate Finance, Cost Of Capital, Interest, Dividend yield, Weighted average cost of capital