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CHAPTER 11

Cost of Capital
CHAPTER ORIENTATION
In Chapters 7 and 8, we considered the valuation of debt and equity instruments. The concepts
advanced there serve as a foundation for determining the required rate of return for the firm and
for specific investment projects. The objective in this chapter is to determine the required rate of
return to be used in evaluating investment projects.

CHAPTER OUTLINE

I. The concept of the cost of capital


A. Defining the cost of capital:
1. The rate that must be earned in order to satisfy the required rate of return
of the firm’s investors.
2. The rate of return on investments at which the price of a firm’s common
stock will remain unchanged.
B. Type of investors and the cost of capital.
1. Each source of capital used by the firm (debt, preferred stock, and
common stock) should be incorporated into the cost of capital, with the
relative importance of a particular source being based on the percentage of
the financing provided by each source.
2. Using the cost of a single source of capital as the hurdle rate is tempting
to management. For example, this is particularly true when an investment
is financed entirely by debt. However, doing so is a mistake in logic and
can cause problems.
II. Factors determining the cost of capital
A. General economic conditions. These include the demand for and supply of capital
within the economy and the level of expected inflation. These are reflected in the
riskless rate of return.
B. Market conditions. The security may not be readily marketable when the investor
wants to sell; or even if a continuous demand for the security does exist, the price
may vary significantly.

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C. A firm’s operating and financing decisions. Risk also results from the decisions
made within the company. This risk is generally divided into two classes:
1. Business risk is the variability in returns on assets and is affected by the
company’s investment decisions.
2. Financial risk is the increased variability in returns to the common
stockholders as a result of using debt and preferred stock.
D. In summary, as the level of risk rises, a larger risk premium must be earned to
satisfy a firm’s investors.
III. Computing the weighted cost of capital. A firm’s weighted cost of capital is a function of
(l) the individual costs of capital and (2) the capital structure mix.
A. Determining individual costs of capital.
1. The before-tax cost of debt is found by solving for kd in
n $I t $M
NPd = ∑ t
+
(1 + k d ) n
t = 1 (1 + k d )

where NPd = the market price of the debt, less flotation costs,
$It = the annual dollar interest paid to the investor each
year,
$M = the maturity value of the debt,
kd = before-tax cost of the debt (before-tax required
rate of return on debt)
n = the number of years to maturity.
The after-tax cost of debt equals:
kd(1 - T)
2. Cost of preferred stock (required rate of return on preferred stock), kps,
equals the dividend yield based upon the net price (market price less
flotation costs) or
dividend D
kps = =
net price NPps

3. Cost of Common Stock. We use two measurement techniques to obtain


estimates of the required rate of return on common stock.
a. dividend-growth model
b. capital asset pricing model

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4. Dividend-growth model
a. Cost of internally generated common equity, kcs

dividend in year 1  annual growth 


kcs = +  
market price  in dividends 
D1
kcs = + g
Po
b. Cost of new common stock, kncs

D1
kncs = + g
NPcs
where NPcs = the market price of the common stock less
flotation costs incurred in issuing new shares.
5. Capital asset pricing model
kcs = krf + β(km - krf)
where kcs = the cost of common stock
krf = the risk-free rate

β = beta, measure of the stock’s systematic risk


km = the expected rate of return on the market
6. It is important to notice that the major difference between the equations
presented here and the equations from Chapter 5 is that the firm must
recognize the flotation costs incurred in issuing the security.
B. Selection of weights. The individual costs of capital will be different for each
source of capital in the firm’s capital structure. To use the cost of capital in
investment analyses, we must compute a weighted or overall cost of capital.
1. It will be assumed that the company’s current financial mix resulting from
the financing of previous investments is relatively stable and that these
weights will closely approximate future financing patterns.
2. In computing weights, we can either use the current market values of the
firm’s securities or the book values as shown in the balance sheet. Since
we will be issuing new securities at their current market value, and not at
book (historical) values, we should use the market value of the securities
in calculating our weights.

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IV. PepsiCo approach to weighted average cost of capital
A. PepsiCo calculates the divisional cost of capital for its snack, beverage, and
restaurant organizations by first finding peer-group firms for each division and
using their average betas, after adjusting for differences in financial leverage, to
compute the division’s cost of equity. They also use accounting betas in
estimating the cost of equity. They then compute the cost of debt for each
division. Finally, they calculate a weighted cost of capital for each division.
B. PepsiCo’s WACC basic computation
 E   D 
ko = kcs   + kd[1-T]  
D+E D+E
where:
ko = the weighted average cost of capital
kcs = the cost of equity capital
kd = the before-tax cost of debt capital
T = the marginal tax rate
E/(D+E) = percentage of financing from equity
D/(D+E) = percentage of financing from debt
C. Calculating the Cost of Equity
Based on capital assets pricing model:
kcs = krf + β (km - krf)
where:
kcs = the cost of common stock
krf = the risk-free rate

β = beta, measure of the stock’s systematic risk


km = the expected rate of return on the market
Betas for each division are estimated by calculating an average unlevered beta
from a group of divisional peers.
The average beta for each division’s peer group is unlevered and then re-levered
using that division’s target debt-to-equity ratio.

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D. Calculating the Cost of Debt
The after-tax cost of debt is equal to:
kd (1 - T)
where:
kd = before-tax cost of debt
T = marginal tax rate
V. Market Value Added, Wealth Creation and Economic Profit
A. We can tell whether a firm has created value by comparing the market value of all
its outstanding securities (the market value of the right hand side of its balance
sheet) with the total amount of money that has been invested in the firm
(approximately the book value of the firm’s assets). This difference is commonly
referred to as Market Value Added or MVA.
B. MVA is used to rank firms in order of their wealth creation and the 1,000 largest
U.S. firms are listed each Spring in Fortune Magazine.
C. MVA is analogous to the net present value of the firm in that it compares the
market value of the firm (i.e., the present value of the firm’s anticipated future
cash flows) to the total money invested in the firm (analogous to the initial outlay
in a capital budgeting exercise).
D. MVA, in turn, is related to the firm’s annual economic profit. Economic profit
(Stern-Stewart use the term Economic Value Added) for year t is defined as
follows:
Net  Cost 
Exonomic  Tax     Invested 
= Operating 1 −  −  of   
Profit t  Capital 
Income t 
Rate   Capital   t -1 
 
Note that economic profit is a flow measure like net income whereas MVA is a
stock measure like retained earnings. The relationship between MVA measured
today and Economic profit is the following:
∞ Economic Profit t
MVA = ∑ t
t =1  Cost of 
1 + 
 Capital 
That is, MVA is nothing more than the market’s assessment of the value of the
firm’s future economic profits. Consequently, economic profit is often used to
measure the contribution to shareholder wealth for the period.

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VI. Paying for Performance
A. Economic profit or EVA is used by a growing number of U.S. and foreign
corporations as the basis for evaluating financial performance and consequently
for determining incentive compensation.
B. The following relationship offers a simple way to connect economic profit to
incentive compensation in period t:

Incentive Base Percent Actual Economic Profit t


Compensation t = Pay t x Incentive x
Compensation Target Economic Profit t
Incentive compensation for period t then is equal to the product of the manager’s
Base Pay for the period times the Percent of her pay that is to be paid as incentive
compensation times the ratio of actual performance (measured by Economic
Profit for period t) to target performance. The idea here is that the fraction of a
manager’s pay that is tied to performance will vary with higher levels of
management having a larger proportion of their pay tied to performance and the
actual level of incentive pay corresponds to a comparison of actual and target
performance.

ANSWERS TO
END-OF-CHAPTER QUESTIONS
11- 1. The cost of capital is the rate of return that the firm must earn on its investments in order
to satisfy the required rates of return of all the firm’s sources of financing (including
creditors who loan the firm money and owners who purchase shares of stock in the
company). This rate is a function of the required rates of return for all the firm’s sources
of financing, the corporation’s tax rate, and the flotation costs incurred in issuing new
securities. Therefore, the cost of capital determines the rate of return that must be
achieved on the company’s investments, so as to earn the target return of the firm’s
investors. Furthermore, the cost of capital is also the rate of return that will leave the
price of the common stock unchanged.
11- 2. Two objectives may be given for determining a company’s cost of capital:
a. The financial objective of management is to maximize the shareholders’ wealth.
We can increase the value of the common stock by lowering the firm’s cost of
capital. All else remaining the same, as the cost of capital is decreased, the value
of the firm is increased.
b. The cost of capital is used as the minimum acceptable rate of return for capital
investments. The value of the firm is maximized by accepting all projects where
the net present value is positive when discounted at the firm’s cost of capital.

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11- 3. All types of capital, including debt, preferred stock, and common stock, should be
incorporated into the cost of capital computation, with the relative importance of a
particular source being based upon the percentage of financing to be provided.
11- 4. The effect of taxes on the firm’s cost of capital is observed in computing the cost of debt.
Since interest is a tax-deductible expense, the use of debt indirectly decreases the firm’s
taxes. Therefore, since we have computed the internal rate of return on an after-tax
basis, we also compute the cost of debt on an after-tax basis. In completing a security
offering, investment bankers and other involved individuals receive a commission for
their services. As a result, the amount of capital net of these flotation costs is less than
the funds invested by the individual purchasing the security. Consequently, the firm
must earn more than the investors’ required rate of return to compensate for this leakage
of capital.
11- 5. a. Equity capital can be raised either by retaining profits within the firm or by
issuing new common stock. Either route represents funds invested by the
common stockholder. The first avenue simply indicates that the common
stockholder permits management to retain capital that could be remitted to these
investors.
b. Even though a new stock issue does not result from retaining internal common
equity, these funds should not be reinvested unless management can reasonably
expect to satisfy the investors’ required rate of return. In essence, even though no
explicit out-of-pocket cost results from retaining the capital, the cost in measuring
a firm’s cost of capital is actually the opportunity cost associated with these funds
for the investor.
c. The two popular methods for computing the cost of equity capital include (1) the
dividend-growth model, and (2) the capital asset pricing model. The first
approach finds the rate of return that equates the present value of future
dividends, assuming a constant growth rate, with the current market price of the
security. The CAPM finds the appropriate required rate of return, given the
firm’s systematic risk.
11- 6. We would need to calculate a cost of capital or required rate of return for each project
with risk that is different from that of the firm as a whole. The suggested method
described in the chapter relies on the CAPM for this purpose.

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SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
The following notations are used in this group of problems:
kps = the cost of preferred stock.
kcs = the cost of internally generated common funds
kncs = the cost of new common stock.
g = the growth rate.
kd = the before-tax cost of debt.
T = the marginal tax rate.
Dt = dollar dividend per share, where D0 is the most recently paid
dividend and D1 is the forthcoming dividend.
P0 = the value (present value) of a security.
NP0 = the value of a security less any flotation costs incurred in issuing
the security.

11- 1. a. Net price after flotation costs = $1,125 (1 - .05)


= $1,068.75
10 $110 $1,000
$1,068.75 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )10

kd = 9.89%
After − tax = kd(1 - T)
cost of debt

a. After − tax = 9.9%(1-.34) = 6.53%


cost of debt
D1
b. kncs = + g
NP0

$1.80(1 + .07)
= + .07
$27.50(1 − .05)
= .1437 = 14.37%
D1
c. kcs = + g
P0

$3.50
= + .07
$43
= .1514 = 15.14%

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D .09 x ($150)
d. kps = =
NP0 $175(1 − .12)

$13.50
=
$154
= .0877 = 8.77%

e. After − tax = kd(1 - T)


cost of debt
= 12% (1 - .34)
= 7.92%

11- 2. a. After − tax = kd(1 - T)


cost of debt
= 7%(1 - 0.34)
= 4.62%
D1
b. kncs = + g
NP0

$1.05(1 + 0.04)
kncs = + 0.04 = 8.00%
$30(1 − 0.09)
c. $1,150(.90) = $1,035 = net price after flotation costs
15
$120 $1, 000
$1,035 = ∑
t =1 (1 + k d ) t
+
(1 + k d )15

kd = 11.5%
After-tax cost of debt = 11.50% (1-.34) = 7.59%
D
d. kps =
NP
0
$6
kps = = 7.06%
$85
D1
e. kcs = + g
P0

$4
kcs = + 0.04 = 15.43%
$35

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D1
11- 3. kncs = + g
NP0

$1.45(1 + 0.06)
kncs = + 0.06 = .1206 = 12.06%
$27(1 − 0.06)

11- 4. $958 (1 - 0.11) = $852.62 = the net price (value less flotation costs).
15 $70 $1,000
$852.62 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )15
kd = 8.81%
After − tax = 8.82% (1 - 0.18) = 7.22%
cost of debt

D $3.00
11- 5. kps = = = 9.23%
NP0 $32.50

n $M
$I t
11- 6. NP0 = ∑ (1 + k d ) t
+
t =1 (1 + k d ) n
15 $120 $1,000
$945 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )15
Since the net price on the bonds, $945, is less than the $1,000 par value, the before-tax
cost of the debt must be greater than the 12% coupon interest rate ($120 ÷ $1,000).
kd = 12.85%

After − tax = kd(1 - T) = 12.85%(1 - .34) = 8.48%


cost of debt

11- 7. Cost of preferred stock (kps)


Dividend D
= =
Net Price NP0

14% x $100 $14


= =
$98 $98
= 14.29%

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D1
11-8. kcs = + g
P0

$0.70(1 + 0.15)
= + 0.15
$23.80
= .1838 = 18.38%
11 9. If the firm pays out 50% of its earnings in dividends, its recent earnings must have been
$8 ($4 dividend divided by .5).
Thus, earnings increased from $5 to $8 in 5 years. Using Appendix C and looking for a
table value of .625 ($5/$8), the annual growth rate is approximately 10%.
a. Cost of internal common funds (kcs):

D 
kcs =  1 + g
P 
 0
$4(1 + .10) $4.40
= + .10 = + .10
$58 $58
= .1759 = 17.59%
b. Cost of external common (new common) stock, kncs

 D1 
kncs =  
 NP  + g
 o
$4.40
= + .10
$58(1 − 0.08)
$4.40
= + .10
$53.36
= .1825 = 18.25%
10 $140 $1,000
11-10. a. Price (P0) = ∑ t
+
t = 1 (1 + 0.09) (1 + 0.09)10
= $140(6.418) + $1000(.422)
= $1,320.52
b. NP0 = $1,320.52(1 - 0.105)
= 1,181.87
$500,000
c. Number of Bonds = = 423 Bonds
$1,181.87

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d. Cost of debt:
10 $140 $1,000
$1,181.87 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )10
kd = 10.92%

After − tax = 10.92%(1 - 0.34) = 7.21%


cost of debt
10
$80 $1,000
11-11. a. i. Price (P0) = ∑ (1 + 0.09) t
+
t=1 (1 + 0.09)10
= $935.82
ii. NP0 = $935.82 (1 - 0.105)

= $837.56
$500, 000
iii. Number of Bonds =
$837.56
= 597 Bonds
iv. Cost of debt:
10
$80 $1,000
$837.56 = ∑
t=1 (1 + k d ) t
+
(1 + k d )10

kd = 10.73%

After − tax = 10.73%(1 - 0.34) = 7.08%


cost of debt
b. There is a very slight decrease in the cost of debt because the flotation costs
associated with the higher coupon (and higher price) bond in Problem 11- 10 are
higher.

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11-12. The following table provides the basis for responding to parts a. and b. of this problem.

($millions) Invested Market Economic


Firm MVA Capital ROIC Value NOPAT Kwacc Profit
Wal Mart Stores 282,655.00 54,013.00 14.31% 336,668.00 7,729.26 10.99% 1,793.23
Yahoo! 128,748.00 8,847.00 -2.66% 137,595.00 (235.33) 15.99% (1,649.97)
Motorola 70,541.00 29,890.00 7.35% 100,431.00 2,196.92 11.65% (1,285.27)

a. Only Wal Mart earned a positive profit after accounting for its capital costs (i.e., a
positive economic profit).
b. Market value added is the difference in the market value of the firm’s securities
(the sum of the values of the firm’s outstanding debt and equity) less the total
amount of invested capital provided by these same security holders. All three of
the firms in the above table had positive MVAs although only one earned a
positive economic profit for the year. Remember that MVA is the present value
of all future anticipated economic profits so having a negative economic profit in
one year does not indicate that the firm does not have a positive MVA (and vice
versa).
11-13 The information provided in the text for this problem is found below:
Proposed
Employee Last Year’s % Incentive Target Base
Title Compensation Pay Performance Compensation
Chief Executive Officer 750,000 90% 5,000,000 75,000
Chief Operating Officer 500,000 80% 5,000,000 100,000
Chief Financial Officer 425,000 50% 5,000,000 212,500
Controller 275,000 30% 5,000,000 192,500
a. Using the following relationship we can calculate the compensation for each of
the four officers where the ratio of actual to target performance is .8, 1.0, and 1.2,
i.e.
 Percent 
Incentive = Base Pay x  Incentive  x  Actual Performanc e 
Compensation  Compensation   Target Performanc e 
 

Employee Last Year’s Incentive Compensation Total Compensation


Title Compensation 80% 100% 120% 80% 100% 120%
Chief Executive Officer 750,000 540,000 675,000 810,000 615,000 750,000 885,000
Chief Operating Officer 500,000 320,000 400,000 480,000 420,000 500,000 580,000
Chief financial Officer 425,000 170,000 212,500 255,000 382,500 425,000 467,500
Controller 275,000 66,000 82,500 99,000 258,500 275,000 291,500

It is obvious from these results that under the new compensation plan there will
be no change in compensation if the firm manages to achieve 100% of the target
performance. However, if performance rises above or falls below 100% the
employee’s compensation will vary accordingly and fairly dramatically.

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b. If compensation is capped at 150% of the target and a floor is set at 60% of the
target then the bounds for compensation for the four officers will be the
following:

Employee Incentive Compensation Total Compensation


Title 60% 150% 60% 150%
Chief Executive Officer 405,000 1,012,500 480,000 1,087,500
Chief Operating Officer 240,000 600,000 340,000 700,000
Chief Financial Officer 127,500 318,750 340,000 531,250
Controller 49,500 123,750 242,000 316,250
Note that where performance drops below the 60% barrier management has no incentive
to try to improve unless they think they can get above the barrier. Similarly, once
performance reaches 150% there is no incentive to improve further.

11-14 This problem provides the basis for discussing some of the difficult issues that arise in
evaluating the cost of capital for a multi-division firm.
a. Pete runs the high risk exploration division of the company and is likely to be
hurt by the use of risk based divisional costs of capital. He argues that the firm
should simply pursue its most promising investment opportunities regardless of
other considerations. In essence he argues for ignoring risk considerations. If his
advice is followed, we would expect to see the firm invest excessively in high
risk ventures which generally promise the highest returns.
b. Donna’s situation is exactly the opposite of Pete’s. Here she finds her division
fighting for funds to invest in lower return (but lower risk) projects that will
produce wealth (albeit at a slower and safer pace).
c. This is where “the rubber meets the road” for using divisional costs of capital to
calculate economic profit or Economic Value Added. Pete must earn a higher
return just to meet his capital cost requirement than Donna. Is this fair? Yes it is.
To require Pete to meet a higher standard to deploy capital in his exploration
activities is completely consistent with asking him to earn more on the capital he
has already invested.

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11-15. a.

Given:

Cash $ 540,000
Accounts Receivable 4,580,000
Inventories 7,400,000 Long-term Debt $12,590,000
Net Property, Plant & Equipment 18,955,000 Common Equity 18,885,000
Total Assets $31,475,000 $31,475,000

Cost of debt financing 8%


Cost of equity 15%
Tax rate 34%
Market to book ratio 1.00

Solution:
Market Value
Component Proportion After-tax Cost Product Balance Sheet
Long-term Debt 40% 5.28% 2.11200% $ 12,590,000
Common Equity 60% 15.00% 9.00000% 18,885,000
11.11200% $ 31,475,000

b.

Given:

Cash $ 540,000
Accounts Receivable 4,580,000
Inventories 7,400,000 Long-term Debt $12,590,000
Net Property, Plant & Equipment 18,955,000 Common Equity 18,885,000
Total Assets $31,475,000 $31,475,000

Cost of debt financing 8%


Cost of equity 13%
Tax rate 34%
Market to book ratio 1.50

Solution:
Market Value
Component Proportion After-tax Cost Product Balance Sheet
Long-term Debt 40% 5.28% 2.11200% $ 12,590,000
Common Equity 60% 13.00% 7.80000% 28,327,500
9.91200% $ 40,917,500

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11-16.

Given:
Manufacturing Distribution
Division Division
Equity beta 1.6 1.1
Tax rate 35.0% 35.0%
Cost of Debt 8.0% 8.0%
Debt ratio 40.0% 40.0%

Risk free rate 4.8%


Market risk premium 7.3%

a.
Manufacturing Division
After-tax
Component Proportion Cost Product
Debt 40.0% 5.20% 2.0800%
Equity 60.0% 8.80% 5.2800%
Divisional WACC 7.3600%

Distribution Division
After-tax
Component Proportion Cost Product
Debt 40.0% 5.20% 2.0800%
Equity 60.0% 7.55% 4.5300%
Divisional WACC 6.6100%

b. The investment in the distribution division is definitely preferred assuming all


else is the same between the two investments (i.e., the size of the investment). In
the Manufacturing division a 12 percent project returns a near zero NPV whereas
in the Distribution division the project is a positive NPV investment. We cannot
know the size of the NPV but if both projects are of roughly equal dollar size the
distribution project would be preferred.

11-17. a.

2001 2002 2003 2004 2005 2006


NOI $142,500 $162,200 $158,000 $168,200 $187,100
Invested Capital $750,250 $780,220 842,000 1,050,100 $1,420,200
Tax Rate 35%
Cost of Capital 10%
EVA $17,600 $27,408 $18,500 $4,320 $(20,405)

b. Yes. The buildup in inventories has contributed to the growth in the firm’s
invested capital. This growth in asset base has caused a rather dramatic decline in
the firm’s EVA.

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SOLUTIONS TO COMPREHENSIVE PROBLEM
a. Weighted Cost of Capital

Cost of Debt:
$1,035 (1 - .15) = $879.75 = NP0
16 $80 $1,000
$879.75 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )16
kd = 9.49%

After − tax = 9.51%(1 - .34) = 6.26%


cost of debt
Cost of Preferred Stock:
D $1.50
kps = = = 8.83%
NP0 ($19 − $2.01)

Cost of Internal Common Funds:


D1
kcs = + g
P0

$2.50(1 + 0.06)
= + 0.06
$35
= .1357 = 13.57%
Weighted Cost of Capital (Kwacc) using internal common funds only.

Weights Costs Weighted Costs


Bonds 0.38 6.26% 0.0238
Preferred Stock 0.15 8.83% 0.0132
New Common Stock 0.47 13.57% 0.0638
1.00 .1008 or 10.08%

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b. Raising external common equity
Cost of External Common Stock:
D1
kncs = + g
NPo
$2.50(1 + 0.06)
= + 0.06
$35 − $1.21
= .1414 = 14.14%
Weighted Cost of Capital (Kwacc) using external common funds only.

Weights Costs Weighted Costs


Bonds 0.38 6.26% 0.0238
Preferred Stock 0.15 8.83% 0.0132
New Common Stock 0.47 14.14% 0.0665
1.00 .1035 or 10.35%

ALTERNATIVE PROBLEMS AND SOLUTIONS


ALTERNATIVE PROBLEMS

11- 1A. (Individual or Component Costs of Capital) Compute the cost for the following sources
of Financing:
a. A bond that has a $1,000 par value (face value) and a contract or coupon interior
rate of 12%. A new issue would have a flotation cost of 6% of the $1,125 market
value. The bonds mature in 10 years. The firm’s average tax rate is 30% and its
marginal tax rate is 34%.
b. A new common stock issue that paid a $1.75 dividend last year. The par value of
the stock is $15, and earnings per share have grown at a rate of 8% per year. This
growth rate is expected to continue into the foreseeable future. The company
maintains a constant dividend/earnings ratio of 30%. The price of this stock is
now $28, but 5% flotation costs are anticipated.
c. Internal common equity where the current market price of the common stock is
$43.50. The expected dividend this coming year should be $3.25, increasing
thereafter at a 7% annual growth rate. The corporation’s tax rate is 34%.
d. A preferred stock paying a 10% dividend on a $125 par value. If a new issue is
offered, flotation costs will be 12% of the current price of $150.

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e. A bond selling to yield 13% after flotation costs, but prior to adjusting for the
marginal corporate tax rate of 34%. In other words, 13% is the rate that equates
the net proceeds from the bond with the present value of the future cash flows
(principal and interest).
11- 2A. (Individual or Component Costs of Capital) Compute the cost for the following sources
of financing:
a. A bond selling to yield 9% after flotation costs, but prior to adjusting for the
marginal corporate tax rate of 34%. In other words, 9% is the rate that equates
the net proceeds from the bond with the present value of the future flows
(principal and interest).
b. A new common stock issue that paid a $1.25 dividend last year. The par value of
the stock is $2, and the earnings per share have grown at a rate of 6% per year.
This growth rate is expected to continue into the foreseeable future. The
company maintains a constant dividend/earnings ratio of 40%. The price of this
stock is now $30, but 9% flotation costs are anticipated.
c. A bond that has a $1,000 par value (face value) and a contract or coupon interest
rate of 13%. A new issue would net the company 90% of the $1,125 market
value. The bonds mature in 20 years, and the firm’s average tax rate is 30% and
its marginal tax rate is 34%.
d. A preferred stock paying a 7% dividend on a $125 par value. If a new issue is
offered, the company can expect to net $90 per share.
e. Internal common equity where the current market price of the common stock is
$38. The expected dividend this coming year should be $4, increasing thereafter
at a 5% annual growth rate. This corporation’s tax rate is 34%.
11- 3A. (Cost of Equity) Falon Corporation is issuing new common stock at a market price of
$28. Dividends last year were $1.30 and are expected to grow at an annual rate of 7%
forever. Flotation costs will be 6% of market price. What is Falon’s cost of equity?
11- 4A. (Cost of Debt) Temple is issuing a $1,000 par value bond that pays 8% annual interest
and matures in 15 years. Investors are willing to pay $950 for the bond. Flotation costs
will be 11% of market value. The company is in a 19% tax bracket. What will be the
firm’s after-tax cost of debt on the bond?
11- 5A. (Cost of Preferred Stock) The preferred stock of Gator Industries sells for $35 and pays
$2.75 in dividends. The net price of the security after issuance costs is $32.50. What is
the cost of capital for the preferred stock?
11- 6A. (Cost of Debt) The Walgren Corporation is contemplating a new investment to be
financed 33% from debt. The firm could sell new $1,000 par value bonds at a net price
of $950. The coupon interest rate is 13%, and the bonds would mature in fifteen years.
If the company is in a 34% tax bracket, what is the after-tax cost of capital to Walgren
for bonds?

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11- 7A. (Cost of Preferred Stock) Your firm is planning to issue preferred stock. The stock
sells for $120; however, if new stock is issued, the company would receive only $97.
The par value of the stock is $100, and the dividend rate is 13%. What is the cost of
capital for the stock to your firm?
11- 8A. (Cost of Internal Equity) The common stock for Oxford, Inc. is currently selling for
$22.50. Dividends last year were $.80. Flotation costs on issuing stock will be 10% of
market price. The dividends and earnings per share are projected to have an annual
growth rate of 16%. What is the cost of internal common equity for Oxford?
11- 9A. (Cost of Equity) The common stock for the Hetterbrand Corporation sells for $60. If a
new issue is sold, the flotation cost is estimated to be 9%. The company pays 50% of its
earnings in dividends, and a $4.50 dividend was recently paid. Earnings per share 5
years ago were $5. Earnings are expected to continue to grow at the same annual rate in
the future as during the past 5 years. The firm’s marginal tax rate is 35%. Calculate the
cost of (a) internal common and (b) external common stock.
11- 10A. (Cost of Debt) Gillian Stationery Corporation needs to raise $600,000 to improve its
manufacturing plant. It has decided to issue a $1,000 par value bond with a 15% annual
coupon rate and a 10-year maturity. If the investors require a 10% rate of return:
a. Compute the market value of the bonds.
b. What will the net price be if flotation costs are 11.5% of the market price?
c. How many bonds will the firm have to issue to receive the needed funds?
d. What is the firm’s after-tax cost of debt if its average tax rate is 25% and its
marginal tax rate is 34%?
11- 11A. (Cost of Debt)
a. Rework problem 11-10A assuming a 10 percent coupon rate. What effect does
changing the coupon rate have on the firm’s after-tax cost of capital?
b. Why is there a change?
11- 12A. (Weighted Cost of Capital) The capital structure for the Bias Corporation is provided
below. The company plans to maintain its debt structure in the future. If the firm has a
6% after-tax cost of debt, a 13.5% cost of preferred stock, and a 19% cost of common
stock, what is the firm’s weighted cost of capital?
Capital Structure ($000)
Bonds $1,100
Preferred stock 250
Common stock 3,700
$5,050

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SOLUTIONS FOR ALTERNATIVE PROBLEMS
The following notations are used in this group of problems:
kps = the cost of preferred stock.
kcs = the cost of internally generated common funds
kncs = the cost of new common stock.
g = the growth rate.
kd = the before-tax cost of debt.
T = the marginal tax rate.
Dt = dollar dividend per share, where D0 is the most recently paid
dividend and D1 is the forthcoming dividend.
P0 = the value (present value) of a security.
NP0 = the value of a security less any flotation costs incurred in issuing
the security
11- 1A. a. Net price after flotation costs = $1,125 (1 - .06)
= $1,057.50
10
$120 $1,000
$1,057.50 = ∑
t =1 (1 + k d ) t
+
(1 + k d )10
kd = 11.02%
After − tax = kd(1 - T)
cost of debt
After − tax = 11.02%(1 - .34) = 7.27%
cost of debt
D1
b. kncs = + g
NP0
$1.75(1 + .08)
= + .08
$28.00(1 − .05)
= .1511 = 15.11%
D1
c. kcs = + g
P0
$3.25
= + .07
$43.50
= .1447 = 14.47%

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D .10 X $125
d. kps = =
NP0 $150(1 − .12)
$12.5
=
$132
= .0947 = 9.47%

e. After − tax = kd(1 - T)


cost of debt
= 13% (1 - .34)
= 8.58%

11- 2A. a. After − tax = kd(1 - T)


cost of debt
After − tax = 9%(1 - 0.34)
cost of debt
After − tax = 5.94%
cost of debt
D1
b. kncs = + g
NP0
$1.25(1 + 0.06)
kncs = + 0.06 = 10.85%
$30(1 − 0.09)
c. $1,125(.90) = $1,012.50 = net price after flotation costs
20
$130 $1,000
$1,012.50 = ∑
t = 1 (1 + k d )
t
+
(1 + k d ) 20
kd = 12.83%
After − tax = kd(1 - T)
cost of debt
After − tax = 12.83% (1 - 0.34) = 8.47%
cost of debt
D
d. kps =
NP0
$8.75
kps = = 9.72%
$90
D1
e. kcs = + g
P0
$4
kcs = + 0.05 = 15.53%
$38

375
D1
11- 3A. kncs = + g
NP0
$1.30(1 + 0.07)
kncs = + 0.07 = .1229 = 12.29%
$28(1 − 0.06)
11- 4A. $950 (1 - 0.11) = $845.50 = the net price (value less flotation costs).
15 $80 $1,000
$845.50 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )15
kd = 10.04%

After − tax = 10.04% (1 - 0.19) = 8.13%


cost of debt
D $2.75
11- 5A. kps = = = 8.46%
NP0 $32.50
n $M
$I t
11- 6A. NP0 = ∑ (1 + k d ) t
+
t =1 (1 + k d ) n
15 $1,000
$130
$950 = ∑ (1 + k d ) t
+
t =1 (1 + k d )15
Since the net price on the bonds, $950, is less than the $1,000 par value, the before-tax
cost of the debt must be greater than the 13% coupon interest rate ($130 ÷ $1,000).
kd = 13.81%

After − tax = kd(1 - T) = 13.81%(1 - .34) = 9.11%


cost of debt
11- 7A. Cost of preferred stock (kps)
Dividend D
= =
Net Price NP0

13% x $100 $13


= =
$97 $97
= 13.40%

376
D1
11- 8A. kcs = + g
P
0
$0.80(1 + 0.16)
= + 0.16
$22.50
= .2012 = 20.12%
11- 9A. If the firm pays out 50% of its earnings in dividends, its recent earnings must have been
$9 ($4.50 dividend divided by .5).
Thus, earnings increased from $5 to $9 in 5 years. Using Appendix C and looking for a
table value of .556 ($5/$9), the annual growth rate is approximately 12%.
a. Cost of internal common funds (kcs):

D 
kcs =  1 + g
P 
 0
$4.50(1 + .12)
= + .12
$60
$5.04
= + .12
$60
= .204 = 20.4%
b. Cost of external common (new common) stock, kncs
 D 
kncs =  1  + g
 NP 
 0
$5.04
= + .12
$60(1 − 0.09)
$5.04
= + .12
$54.60
= .2123 = 21.23%
10
$150 $1,000
11- 10A. a. Price (P0) = ∑
t =1 (1 + 0.10) t
+
(1 + 0.10) 10
= $150(6.145) + $1000(.386)
= $1,307.75
b. NP0 = $1,307.75(1 - 0.115)
= $1,157.36

377
$600,000
c. Number of Bonds =
$1,157.36
= 518 Bonds
d. Cost of debt:
10 $1,000
$150
$1,157.36 = ∑
t =1 (1 + k d ) t +
(1 + k d )10
kd = .12.20%

After − tax = 12.20%(1 - 0.34) = 8.05%


cost of debt
10 $100 $1,000
11- 11A. a. 1. Price (P0) = ∑
t =1 (1 + 0.10) t +
(1 + 0.10)10
= $100 (6.145) + $1,000 (.386)
= $1,000.00
2. NP0 = $1,000.00 (1 - 0.115)
= $885.00
$600,000
3. Number of Bonds =
$885.00
= 678 Bonds
4. Cost of debt:
10 $100 $1,000
$885.00 = ∑ t
+
t = 1 (1 + k d ) (1 + k d )10
kd = 12.04%

After − tax = 12.04%(1 - 0.34) = 7.95%


cost of debt
b. There is a very slight decrease in the cost of debt because the flotation costs
associated with the higher coupon bond are higher.

11- 12A. Bias Corporation—Weighted Cost of Capital

Capital Individual Weighted


Structure Weights Costs Costs
Bonds $1,100 0.2178 6.0% 1.31%
Preferred Stock 250 0.0495 13.5% 0.67%
Common Stock 3,700 0.7327 19.0% 13.92%
$5,050 1.0000 15.90%

378