1a

Source of Capital
LTD
PS
CS
TOTAL

Capital
Structure
Book Value
Weight
6,000,000.00 6/10
1,000,000.00 1/10
3,000,000.00 3/10
10,000,000.00

Capital
Structure
Weight
0.60
0.10
0.30
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Weight
Costs
3.00%
1.00%
4.50%
8.50% WACC

1b
WACC dictates that all investments should have an internal rate of return above 8.5%.
1c
Debt is less costly because it is less risky from an investor's standpoint thus a lower
return iis demanded by investors. Moreover, interest expense is deductible for tax
purposes creaing cash savings from tax payment reduction.
2a

Source of Capital
LTD
PS
CS
TOTAL

Capital
Structure
Book Value
Weight
3,000,000.00 6/10
1,000,000.00 1/10
6,000,000.00 3/10
10,000,000.00

Capital
Structure
Weight
0.30
0.10
0.60
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Weight
Costs
1.50%
1.00%
9.00%
11.50% WACC

2b
There was an increase in WACC in No. 2
The higher the risks the higher the return. Risk and return trade-off.
3a

Source of Capital
LTD
PS
CS
TOTAL

Capital
Structure
Book Value
Weight
3,000,000.00 6/10
1,000,000.00 1/10
6,000,000.00 3/10
10,000,000.00

Capital
Structure
Weight
0.30
0.10
0.60
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Capital
Structure
Book Value
Weight
2,500,000.00 6/10
1,500,000.00 1/10
9,000,000.00 3/10
13,000,000.00

Capital
Structure
Weight
0.19
0.12
0.69
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Weight
Costs
1.50%
1.00%
9.00%
11.50% WACC

3b

Source of Capital
LTD
PS
CS
TOTAL

Weight
Costs
0.96%
1.15%
10.38%
12.50% WACC

3c
Market values are more reliable as they reflect the true value of the net assets.
3d

Investments with IRR of 12% will be wrongfully accepted by using book values.
4a
Selling price
Less
Floatation cost
Net proceeds, Nd

1,010.00
30.00
980.00

4b
t1
980.00

t2
(120.00)

4c
Appproximation cost of debt formula:
kd
= I + P1,000-Nd/n
Nd + P1,000
'2

t3
(120.00)

t15
(120.00)
(1,000.00)

ki = kd x (1-tax rate)

kd = before tax cost of debt

I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
ki - after tax cost of debt

kd=

P120 + P1,000 - P980/15 years

P980 + P1,000
'2

ki=

12.26% x 1-.40

,=

P120 +
1.3333333 0.122556
990
12.26%

0.073533
7.35%

4d

Cost to Maturity:

n I M
Bo =
+
t
n
t =1 (1 + k) (1 + k)

15 $120 $1,000
$980 =
+
t
15
t =1 (1 + k) (1 + k)

Step 1: Try 12%

V = 120 (6.811) + 1,000 (0.183)
V = 817.32 + 183
V = $1,000.32
(Due to rounding of the PVIF, the value of the bond is 32 cents greater than expected.
At the coupon rate, the value of a $1,000 face value bond is $1,000.)
Try 13%:
V = 120 (6.462) + 1,000 (0.160)

V = 775.44 + 160
V = $935.44
The cost to maturity is between 12% and 13%.
Step 2: $1,000.32 $935.44 = $64.88
Step 3: $1,000.32 $980.00 = $20.32
Step 4: $20.32 $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31 (1 0.40) = 7.39% = after-tax cost of debt
4e
12.26% and 12.31% after tax is 7.35% and 7.39% for approximation and IRR respectively, difference is
negligible.
4f
The value of bonds and interest rate have an inverse relationship.

4g
kd=

ki=
4h
kd=

ki=

P120 + P1,000 - P1,000/15 years

P1,000 + P1,000
'2
12.00% x 1-.40

P120 +
1000

,=

P120 +
-1.333333 0.117492
1010
11.75%

0.070495
7.05%

4i
Discounts increases cost of borrowings while premiums decreases cost of borrowing.
5

kp = Dp Np
Preferred
Stock
A
B
C
D
E

Calculation
kp
kp
kp
kp
kp

0.12
12.00%

0.072
7.20%

P120 + P1,000 - P1020/15 years

P1020 + P1,000
'2
11.75% x 1-.40

,=

=
=
=
=
=

$11.00
3.20
5.00
3.00
1.80

$92.00
34.50
33.00
24.50
17.50

=
=
=
=
=

11.96%
9.28%
15.15%
12.24%
10.29%

B
C
D
E

=
=
=
=

kp
kp
kp
kp

3.20
5.00
3.00
1.80

34.50
33.00
24.50
17.50

=
=
=
=

9.28%
15.15%
12.24%
10.29%

6a&b

Retained Earnings versus New Common Stock

kr =

D1
+g
P0

kn =

Firm

D1
+g
Nn
Calculation

kr = ($2.25 $50.00) + 8% = 12.50%

kn = ($2.25 $47.00) + 8% = 12.79%

kr = ($1.00 $20.00) + 4% = 9.00%

kn = ($1.00 $18.00) + 4% = 9.56%

kr = ($2.00 $42.50) + 6% = 10.71%

kn = ($2.00 $39.50) + 6% = 11.06%

kr = ($2.10 $19.00) + 2% = 13.05%

kn = ($2.10 $16.00) + 2% = 15.13%

6c
Because of floatation costs and underpricing
6d
Retained earnings rightfully belongs to common stockholders.
6e
Signalling theory - investors takes issuance of equity as a sign of companies poor prospects.
7a,b&c

ks = RF + [b (km RF)]
ks = 6% + 1.2 (11% 6%)
ks = 6% + 6%
ks = 12%
(c) Risk premium = 6%
(b) Rate of return = 12%
(a) After-tax cost of common equity using the CAPM = 12%

7d

7e

ks = RF + [b (km RF)]
ks = 6% + 1 (11% 6%)
ks = 6% + 5%
ks = 11%

ks = RF + [b (km RF)]
ks = 6% + .90 (11% 6%)
ks = 6% + 4.5%
ks = 10.5%

ks = RF + [b (km RF)]
ks = 6% + .90 (11% 6%)
ks = 6% + 4.5%
ks = 10.5%
7f
Risk free rate is the rate from t-bills or govt. bonds, market return is the return paid by the market which
is higher than the risk free rate and beta is a measure of volatility of the stock price which is measure of
risk.
8

(a)

g=
g=

D2006
= FVIFk%,4
D2002

$3.10
= 1.462
$2.12

From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).
Calculator solution: 9.97%
(b) Nn = $52 (given in the problem)
D
(c) k r = 2007 + g
P0

$3.40
+ 0.10 = 15.91%
$57.50
D
(d) Kn k r = 2007 + g
Nn
kr =

Kn=$3.40/$52+.10 = 16.54%

(a)

Cost of Retained Earnings

kr =

$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 3.35% + 6% = 9.35%
$40.00
$40.00

(b) Cost of New Common Stock

ks =
(c)

Cost of Preferred Stock

kp =

(d)

$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 4.06% + 6% = 10.06%
$40.00 $7.00
$33.00

kd =

$2.00
$2.00
=
= 9.09%
$25.00 $3.00 $22.00
$1,000 $1,175
$65.00
5
=
= 5.98%
$1,175 + $1,000
$1,087.50
2

$100 +

ks =
(c)

$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 4.06% + 6% = 10.06%
$40.00 $7.00
$33.00

Cost of Preferred Stock

kp =

$2.00
$2.00
=
= 9.09%
$25.00 $3.00 $22.00

$1,000 $1,175
$65.00
5
kd =
=
= 5.98%
$1,175 + $1,000
$1,087.50
2
ki = 5.98% (1 0.40) = 3.59%
$100 +

(d)

$4,200,000 ($1.26 1,000,000) $2,940,000

=
= $5,880,000
0.50
0.50

(e)

BPcommon equity =

(f)

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(9.35%)

WACC = 1.436 + 0.909 + 4.675
WACC = 7.02%
This WACC applies to projects with a cumulative cost between 0 and $5,880,000.

(g)

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(10.06%)

10a
WACC = 1.436 + 0.909 + 5.03
Its a wrong decision because an investment with an IRR of 8% was accepted while an investment with

WACC = 7.375%

This WACC applies to projects with a cumulative cost over $5,880,000.

10b

Source of Capital
LTD
PS
CS
TOTAL

Capital
Capital
Structure Structure
Book Value
Weight
Weight
60,000.00 6/10
0.60
0
0.00
40,000.00 4/10
0.40
100,000.00
1.00

Reject project Apple and acccept project Mona.

After
Tax
Costs
7.00%
0.00%
16.00%

Weight
Costs
4.20%
0.00%
6.40%
10.60% WACC

ears).

,000.

1a
Liabilities
Capital
Capital
And Equity
Structure Structure
Assets
Source of Capital
Book Value
Weight
Weight
Current Assets - Cash10,000,000.00 Long Term Debt
6,000,000.00 6/10
0.60
Fixed Assets
Preferred Stock
1,000,000.00 1/10
0.10
Common Stock
3,000,000.00 3/10
0.30
TOTAL ASSETS
10,000,000.00 TOTAL
10,000,000.00
1.00
1b
WACC dictates that all investments should have an internal rate of return above 8.5%.
1c
Debt is less costly because it is less risky from an investor's standpoint thus a lower
return iis demanded by investors. Moreover, interest expense is deductible for tax
purposes creaing cash savings from tax payment reduction.
2a

Source of Capital
LTD
PS
CS
TOTAL

Book Value
3,000,000.00 6/10
1,000,000.00 1/10
6,000,000.00 3/10
10,000,000.00

Capital
Structure
Weight

Capital
Structure
Weight
0.30
0.10
0.60
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Weight
Costs
1.50%
1.00%
9.00%
11.50%

2b
There was an increase in WACC in No. 2
The higher the risks the higher the return. Risk and return trade-off.
3a

Source of Capital
LTD
PS
CS
TOTAL

Book Value
3,000,000.00 6/10
1,000,000.00 1/10
6,000,000.00 3/10
10,000,000.00

Capital
Structure
Weight

Capital
Structure
Weight
0.30
0.10
0.60
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Capital
Structure
Weight

Capital
Structure
Weight
0.19
0.12
0.69
1.00

After
Tax
Costs
5.00%
10.00%
15.00%

Weight
Costs
1.50%
1.00%
9.00%
11.50%

3b

Source of Capital
LTD
PS
CS
TOTAL

Market Value
2,500,000.00
1,500,000.00
9,000,000.00
13,000,000.00

0.19
0.12
0.69

3c
Market values are more reliable as they reflect the true value of the net assets.
3d
Investments with IRR of 12% will be wrongfully accepted by using book values.

Weight
Costs
0.96%
1.15%
10.38%
12.50%

4a
Selling price
Less
Floatation cost
Net proceeds, Nd

1,010.00
30.00
980.00

4b
t0

t1
(120.00)

980.00
4c
Appproximation cost of debt formula:
kd
= I + P1,000-Nd/n
Nd + P1,000
'2

t2
(120.00)

ki = kd x (1-tax rate)

kd = before tax cost of debt

I = stated interest
Nd = Net proceeds
n = term of the bond
P1,000 = assuimed face value of the bonds
2 = constant
ki - after tax cost of debt

kd=

P120 + P1,000 - P980/15 years

P980 + P1,000
'2

ki=

12.26% x 1-.40

,=

P120 +
990

0.073533333
7.35%

4d

Cost to Maturity:

n I M
Bo =
+
t
n
(1
+
k)
t =1
(1 + k)

15 $120 $1, 000

$980 =
+
t
15
(1
+
k)
t =1
(1 + k)

Step 1: Try 12%

V = 120 (6.811) + 1,000 (0.183)
V = 817.32 + 183
V = $1,000.32
(Due to rounding of the PVIF, the value of the bond is 32 cents greater than expected.
At the coupon rate, the value of a $1,000 face value bond is $1,000.)
Try 13%:
V = 120 (6.462) + 1,000 (0.160)
V = 775.44 + 160
V = $935.44

The cost to maturity is between 12% and 13%.

Step 2: $1,000.32 $935.44 = $64.88
Step 3: $1,000.32 $980.00 = $20.32
Step 4: $20.32 $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31 (1 0.40) = 7.39% = after-tax cost of debt
4e
12.26% and 12.31% after tax is 7.35% and 7.39% for approximation and IRR respectively, difference is
negligible.
4f
The value of bonds and interest rate have an inverse relationship.

4g
kd=

P120 + P1,000 - P1,000/15 years

P1,000 + P1,000
'2

ki=

12.00% x 1-.40

4h
kd=

11.75% x 1-.40

P120 +
1000

,=

P120 +
1010

0.072
7.20%

P120 + P1,000 - P1020/15 years

P1020 + P1,000
'2

ki=

,=

0.070495069
7.05%

4i
Discounts increases cost of borrowings while premiums decreases cost of borrowing.
5

kp = Dp Np
Preferred
Stock
A
B
C
D
E

Calculation
kp
kp
kp
kp
kp

=
=
=
=
=

$11.00
3.20
5.00
3.00
1.80

$92.00
34.50
33.00
24.50
17.50

6a&b

Retained Earnings versus New Common Stock

kr =

D1

+g

kn =

D1

+g

=
=
=
=
=

11.96%
9.28%
15.15%
12.24%
10.29%

Retained Earnings versus New Common Stock

kr =

D1
+g
P0

kn =

Firm

D1
+g
Nn
Calculation

kr = ($2.25 $50.00) + 8% = 12.50%

kn = ($2.25 $47.00) + 8% = 12.79%

kr = ($1.00 $20.00) + 4% = 9.00%

kn = ($1.00 $18.00) + 4% = 9.56%

kr = ($2.00 $42.50) + 6% = 10.71%

kn = ($2.00 $39.50) + 6% = 11.06%

kr = ($2.10 $19.00) + 2% = 13.05%

kn = ($2.10 $16.00) + 2% = 15.13%

6c
Because of floatation costs and underpricing
6d
Retained earnings rightfully belongs to common stockholders.
6e
Signalling theory - investors takes issuance of equity as a sign of companies poor prospects.
7a,b&c

ks = RF + [b (km RF)]
ks = 6% + 1.2 (11% 6%)
ks = 6% + 6%
ks = 12%
(c) Risk premium = 6%
(b) Rate of return = 12%
(a) After-tax cost of common equity using the CAPM = 12%

7d

ks = RF + [b (km RF)]
ks = 6% + 1 (11% 6%)
ks = 6% + 5%
ks = 11%

7e

ks = RF + [b (km RF)]
ks = 6% + .90 (11% 6%)
ks = 6% + 4.5%
ks = 10.5%

ks = RF + [b (km RF)]
ks = 6% + .90 (11% 6%)
ks = 6% + 4.5%
ks = 10.5%
7f
Risk free rate is the rate from t-bills or govt. bonds, market return is the return paid by the market which
is higher than the risk free rate and beta is a measure of volatility of the stock price which is measure of
risk.
8

(a)

g=
g=

D2006
= FVIFk%,4
D2002

$3.10
= 1.462
$2.12

From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).
Calculator solution: 9.97%
(b) Nn = $52 (given in the problem)
D
(c) k r = 2007 + g
P0

$3.40
+ 0.10 = 15.91%
$57.50
D
(d) Kn k r = 2007 + g
Nn
kr =

Kn=$3.40/$52+.10 = 16.54%

(a)

Cost of Retained Earnings

kr =

$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 3.35% + 6% = 9.35%
$40.00
$40.00

(b) Cost of New Common Stock

ks =
(c)

$1.26(1 + 0.06)
$1.34
+ 0.06 =
= 4.06% + 6% = 10.06%
$40.00 $7.00
$33.00

Cost of Preferred Stock

kp =

$2.00
$2.00
=
= 9.09%
$25.00 $3.00 $22.00

$1,000 $1,175
$65.00
5
kd =
=
= 5.98%
$1,175 + $1,000
$1,087.50
2
ki = 5.98% (1 0.40) = 3.59%
$100 +

(d)

(e)

BPcommon equity =

$4,200,000 ($1.26 1,000,000)

$2,940,000

= $5,880,000

(c)

Cost of Preferred Stock

kp =

$2.00
$2.00
=
= 9.09%
$25.00 $3.00 $22.00

$1,000 $1,175
$65.00
5
kd =
=
= 5.98%
$1,175 + $1,000
$1,087.50
2
ki = 5.98% (1 0.40) = 3.59%
$100 +

(d)

$4,200,000 ($1.26 1,000,000) $2,940,000

=
= $5,880,000
0.50
0.50

(e)

BPcommon equity =

(f)

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(9.35%)

WACC = 1.436 + 0.909 + 4.675
WACC = 7.02%
This WACC applies to projects with a cumulative cost between 0 and $5,880,000.

(g)

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(10.06%)

10a
WACC = 1.436 + 0.909 + 5.03
Its a wrong decision because an investment with an IRR of 8% was accepted while an investment with

WACC = 7.375%

This WACC applies to projects with a cumulative cost over $5,880,000.

10b

Source of Capital
LTD
PS
CS
TOTAL

Book Value
60,000.00 6/10
40,000.00 4/10
100,000.00

Capital
Structure
Weight

Reject project Apple and acccept project Mona.

Capital
Structure
Weight
0.60
0.00
0.40
1.00

After
Tax
Costs
7.00%
0.00%
16.00%

Weight
Costs
4.20%
0.00%
6.40%
10.60%

After
Tax
Costs
5.00%
10.00%
15.00%

WACC

WACC

WACC

Weight
Costs
3.00%
1.00%
4.50%
8.50% WACC

an expected.

t15
(120.00)
(1,000.00)

1.333333333 0.122556
12.26%

ively, difference is

0.12
12.00%

-1.33333333 0.117492
11.75%

by the market which

which is measure of

or 4 years).

80,000

80,000

5,880,000.

estment with

WACC