Solutions to End-Of-Chapter Problems

10-1 rd(1 – T) = 0.12(0.65) = 7.80%.

10-2 Pp = $47.50; Dp = $3.80; rp = ?

Dp $3.80
rp = = = 8%.
Pp $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 = ?

D1 $3.00
a. rs = +g= + 0.05 = 15%.
P0 $30.00

b. F = 10%; re = ?

D1 $3.00
re = +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
10-6 a. rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23

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.

Chapter 10: The Cost of Capital Answers and Solutions 1

 16.3% 15.4% 16%
rs = = 15.9%.
3

D1
10-7 a. rs = +g
P0
$3.18
= + 0.06
$36
= 14.83%.

b. F = ($36.00 – $32.40)/$36.00 = $3.60/$36.00 = 10%.

c. re = D1/[P0(1 – F)] + g = $3.18/$32.40 + 6% = 9.81% + 6% = 15.81%.

10-8 Debt = 40%, Common equity = 60%.

P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%.

D1 $2.14
rs = +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 Amount Capital Structure Weight

Long-term debt $1,152 40.0%
Common Equity 1,728 60.0
$2,880 100.0%

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%.

Chapter 10: The Cost of Capital Answers and Solutions 2

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 – 0.05)] + 0.12
= 17.26%.

$100(0.11) $11
10-14 rp = = = 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:

Chapter 10: The Cost of Capital Answers and Solutions 3

 g = (1 – Div. payout ratio) ROE = (1 – Div. payout ratio) (NI/Equity)
0.090952 = (1 – Div. payout ratio) ($1,100 million/$6,000 million)
0.090952 = (1 – Div. payout ratio) 0.1833333
0.496104 = (1 – Div. payout ratio)
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%.

D1
10-17 a. rs = +g
P0
$3.60
0.09 = +g
$60.00
0.09 = 0.06 + g
g = 3%.

b. Current EPS $5.400

Less: Dividends per share 3.600
Retained earnings per share $1.800
Rate of return 0.090
Increase in EPS $0.162
Plus: Current EPS 5.400
Next year’s EPS $5.562

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:
After-tax Weighted
Component Weight Cost = Cost
Debt [0.10(1 – T)] 0.15 7.00% 1.05%
Preferred stock 0.10 10.20 1.02
Common stock 0.75 15.72 11.79
WACC = 13.86%

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

Chapter 10: The Cost of Capital Answers and Solutions 4

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:
Required Rate of Cost of
Project Investment Return Capital
A $4 million 14.0% 12%
B 5 million 1.5 12
C 3 million 9.5 8
D 2 million 9.0 10
E 6 million 12.5 12
F 5 million 12.5 10
G 6 million 7.0 8
H 3 million 11.5 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 Rate of Cost of

Project Investment Return Capital
C $3 million 9.5% 8% + 1% = 9%
E 6 million 12.5 12% + 1% = 13%

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%.

D1 (0.55)($ 7.80) $4.29

rs = +g= + 0.08 = + 0.08 = 0.146 = 14.6%.
P0 $65.00 $65.00

Chapter 10: The Cost of Capital Answers and Solutions 5

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

Chapter 10: The Cost of Capital Answers and Solutions 6

Chapter 10: The Cost of Capital Answers and Solutions 7