Solutions to End-Of-Chapter Problems

10-1 10-2

rd(1

T) = 0.12(0.65) = 7.80%.

Pp = $47.50; Dp = $3.80; rp = ? rp =
Dp Pp

$3.80 = 8%. $47.50

10-3

40% Debt; 60% Common equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ? WACC = (wd)(rd)(1 T) + (wc)(rs) 0.0996 = (0.4)(0.09)(1 0.4) + (0.6)rs 0.0996 = 0.0216 + 0.6rs 0.078 = 0.6rs rs = 13%.

10-4

P0 = $30; D1 = $3.00; g = 5%; rs = ? a. rs = D1 $3.00 +g= + 0.05 = 15%. P0 $30.00

b. F = 10%; re = ? re = D1 $3.00 +g = + 0.05 P0 (1  F) $30(1  0.10) = $3.00 + 0.05 = 16.11%. $27.00

10-5 Projects A, B, C, D, and E would be accepted since each project s return is greater than the firm s WACC. D1 $2.14 +g= + 7% = 9.3% + 7% = 16.3%. P0 $23

10-6

a. rs =

b. rs = rRF + (rM rRF)b = 9% + (13% 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%. c. rs = Bond rate + Risk premium = 12% + 4% = 16%. d. Since you have equal confidence in the inputs used for the three approaches, an average of the three methodologies probably would be warranted. rs =
16.3%  15.4%  16% = 15.9%. 3

10-7

a. rs = =

D1 +g P0

$3.18 + 0.06 $36 = 14.83%. $32.40)/$36.00 = $3.60/$36.00 = 10%. F)] + g = $3.18/$32.40 + 6% = 9.81% + 6% = 15.81%.

b. F = ($36.00 c. re = D1/[P0(1 10-8

Debt = 40%, Common equity = 60%. P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%. rs = D1 $2.14 +g= + 7% = 16.51%. P0 $22.50

WACC = (0.4)(0.12)(1 0.4) + (0.6)(0.1651) = 0.0288 + 0.0991 = 12.79%. 10-9 Capital Sources Long-term debt Common Equity Amount $1,152 1,728 $2,880 Capital Structure Weight 40.0% 60.0 100.0%

WACC = wdrd(1 T) + wcrs = 0.4(0.13)(0.6) + 0.6(0.16) = 0.0312 + 0.0960 = 12.72%. 10-10 If the investment requires $5.9 million, that means that it requires $3.54 million (60%) of common equity and $2.36 million (40%) of debt. In this scenario, the firm would exhaust its $2 million of retained earnings and be forced to raise new stock at a cost of 15%. Needing $2.36 million in debt, the firm could get by raising debt at only 10%. Therefore, its weighted average cost of capital is: WACC = 0.4(10%)(1 0.4) + 0.6(15%) = 11.4%. 10-11 rs = D1/P0 + g = $2(1.07)/$24.75 + 7% = 8.65% + 7% = 15.65%. WACC = wd(rd)(1 T) + wc(rs); wc = 1 wd.

13.95% = wd(11%)(1 0.35) + (1 wd)(15.65%) 0.1395 = 0.0715wd + 0.1565 0.1565wd -0.017 = -0.085wd wd = 0.20 = 20%. 10-12 a. rd = 10%, rd(1 T) = 10%(0.6) = 6%.

D/A = 45%; D0 = $2; g = 4%; P0 = $20; T = 40%. Project A: Rate of return = 13%.

Project B: Rate of return = 10%. rs = $2(1.04)/$20 + 4% = 14.40%. b. WACC = 0.45(6%) + 0.55(14.40%) = 10.62%. c. Since the firm s WACC is 10.62% and each of the projects is equally risky and as risky as the firm s other assets, MEC should accept Project A. Its rate of return is greater than the firm s WACC. Project B should not be accepted, since its rate of return is less than MEC s WACC. 10-13 If the firm's dividend yield is 5% and its stock price is $46.75, the next expected annual dividend can be calculated. Dividend yield = D1/P0 5% = D1/$46.75 D1 = $2.3375. Next, the firm's cost of new common stock can be determined from the DCF approach for the cost of equity. re = D1/[P0(1 F)] + g = $2.3375/[$46.75(1 = 17.26%.

0.05)] + 0.12

10-14 rp =

$100(0.11) $11 = = 11.94%. $92.15 $92.15

10-15 a. Examining the DCF approach to the cost of retained earnings, the expected growth rate can be determined from the cost of common equity, price, and expected dividend. However, first, this problem requires that the formula for WACC be used to determine the cost of common equity. WACC = wd(rd)(1 T) + wc(rs) 13.0% = 0.4(10%)(1 0.4) + 0.6(rs) 10.6% = 0.6rs rs = 0.17667 or 17.67%. From the cost of common equity, the expected growth rate can now be determined. rs = D1/P0 + g 0.17667 = $3/$35 + g g = 0.090952 or 9.10%. b. From the formula for the long-run growth rate: g 0.090952 0.090952 0.496104 Div. payout ratio = (1 Div. payout ratio) v ROE = (1 Div. payout ratio) v (NI/Equity) = (1 Div. payout ratio) v ($1,100 million/$6,000 million) = (1 Div. payout ratio) v 0.1833333 = (1 Div. payout ratio) = 0.503896 or 50.39%.

10-16 a. With a financial calculator, input N = 5, PV = -4.42, PMT = 0, FV = 6.50, and then solve for

I/YR = g = 8.02% } 8%. b. D1 = D0(1 + g) = $2.60(1.08) = $2.81. c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.

10-17 a.

rs = 0.09 =

D1 +g P0

$3.60 +g $60.00 0.09 = 0.06 + g g = 3%. $5.400 3.600 $1.800 v 0.090 $0.162 5.400 $5.562

b. Current EPS Less: Dividends per share Retained earnings per share Rate of return Increase in EPS Plus: Current EPS Next year s EPS

Alternatively, EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.

10-18 a. rd(1

T) = 0.10(1

0.3) = 7%.

rp = $5/$49 = 10.2%. rs = $3.50/$36 + 6% = 15.72%. b. WACC: Component Debt [0.10(1 T)] Preferred stock Common stock Weight 0.15 0.10 0.75 v After-tax Cost 7.00% 10.20 15.72 Weighted Cost 1.05% 1.02 11.79 WACC = 13.86% =

c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

10-19 a. If all project decisions are independent, the firm should accept all projects whose returns exceed their risk-adjusted costs of capital. The appropriate costs of capital are summarized below: Project A B C D E F G H Required Investment $4 million 5 million 3 million 2 million 6 million 5 million 6 million 3 million Rate of Return 14.0% 1.5 9.5 9.0 12.5 12.5 7.0 11.5 Cost of Capital 12% 12 8 10 12 10 8 8

Therefore, Ziege should accept projects A, C, E, F, and H. b. With only $13 million to invest in its capital budget, Ziege must choose the best combination of Projects A, C, E, F, and H. Collectively, the projects would account for an investment of $21 million, so naturally not all these projects may be accepted. Looking at the excess return created by the projects (rate of return minus the cost of capital), we see that the excess returns for Projects A, C, E, F, and H are 2%, 1.5%, 0.5%, 2.5%, and 3.5%. The firm should accept the projects which provide the greatest excess returns. By that rationale, the first project to be eliminated from consideration is Project E. This brings the total investment required down to $15 million, therefore one more project must be eliminated. The next lowest excess return is Project C. Therefore, Ziege's optimal capital budget consists of Projects A, F, and H, and it amounts to $12 million. c. Since Projects A, F, and H are already accepted projects, we must adjust the costs of capital for the other two value producing projects (C and E). Required Investment $3 million 6 million Rate of Return 9.5% 12.5 Cost of Capital 8% + 1% = 9% 12% + 1% = 13%

Project C E

If new capital must be issued, Project E ceases to be an acceptable project. On the other hand, Project C's expected rate of return still exceeds the risk-adjusted cost of capital even after raising additional capital. Hence, Ziege's new capital budget should consist of Projects A, C, F, and H and requires $15 million of capital, so $3 million of additional capital must be raised.

10-20 a. After-tax cost of new debt: rd(1

T) = 0.09(1

0.4) = 5.4%.

Cost of common equity: Calculate g as follows: With a financial calculator, input N = 9, PV = -3.90, PMT = 0, FV = 7.80, and then solve for I/YR = g = 8.01% } 8%. rs = D1 (0.55)($7.80) $4.29 +g= + 0.08 = + 0.08 = 0.146 = 14.6%. P0 $65.00 $65.00

b. WACC calculation: Component Debt [0.09(1 T)] Common equity (RE) Weight 0.40 0.60 v After-tax Cost 5.4% 14.6 Weighted = Cost 2.16% 8.76 WACC = 10.92%