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Solutions Manual Principles of Managerial FinanceSolutions Manual Principles of Managerial Finance
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Chapter 9Chapter 9
The Cost of CapitalThe Cost of Capital
InstructorInstructor’’s Resourcess Resources
OverviewOverview
This chapter introduces the student to an important financial concept, the cost of This chapter introduces the student to an important financial concept, the cost of capital. The mechanics ofcapital. The mechanics of
computing the sources of capital debt, preferred stock, common stock, computing the sources of capital debt, preferred stock, common stock, and retained earnings are reviewed. Tand retained earnings are reviewed. Thesehese
individual costs are then combined into a weighted average cost of individual costs are then combined into a weighted average cost of capital. Students are encouraged to devote timecapital. Students are encouraged to devote time
and effort to learning Chapter 9and effort to learning Chapter 9’’s materials because acceptable projects encountered in their professional life ors materials because acceptable projects encountered in their professional life or
investment decisions made in their personal life will be correct investment decisions made in their personal life will be correct if they earn a if they earn a return higher than the cost of capital.return higher than the cost of capital.
Suggested Answers toSuggested Answers to Opener-in-Review Opener-in-Review  Questions Questions
In the chapter opener you learned that AlcoaIn the chapter opener you learned that Alcoa’’s weighted average cost of capital was around 12 percent, buts weighted average cost of capital was around 12 percent, but
its investments were earning returns closer to 5 percent. From 2010 to 2012, Alcoa invested roughly $1its investments were earning returns closer to 5 percent. From 2010 to 2012, Alcoa invested roughly $1
billion in capital expenditures. Suppose billion in capital expenditures. Suppose Alcoa spends $1 billion expanding its manufacturing facilities today,Alcoa spends $1 billion expanding its manufacturing facilities today,
and that investment produces a net cash flow of $50 million (5 and that investment produces a net cash flow of $50 million (5 percent of $1 billion) every year inpercent of $1 billion) every year in
perpetuity. Calculate the NPV of that investment using a 12 percent dperpetuity. Calculate the NPV of that investment using a 12 percent discount rate. How much value does theiscount rate. How much value does the
$1 billion investment create or destroy? Does it seem that Alcoa should be pursuing growth in this market?$1 billion investment create or destroy? Does it seem that Alcoa should be pursuing growth in this market?
 NPV = CF ÷ r NPV = CF ÷ r
Hence, NPV of the Hence, NPV of the investment = $50 million ÷ 12% = investment = $50 million ÷ 12% = $416.67 million$416.67 million
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 179179
Answers to Review QuestionsAnswers to Review Questions
1. The1. The cost of capital cost of capital  represents the firm represents the firm’’s cost of financing in percentage terms. s cost of financing in percentage terms. A firmA firm’’s cost of capital is thes cost of capital is the
expected average future cost of funds over the long run. It is the rate of return a firm must earn on itsexpected average future cost of funds over the long run. It is the rate of return a firm must earn on its
investment in order to maintain the market value investment in order to maintain the market value of its stock.of its stock.
In order to make In order to make any such financing decision, theany such financing decision, the overall cost of capital overall cost of capital  must be considered. This results from must be considered. This results from
the interrelatedness of financing activities. For example, a firm the interrelatedness of financing activities. For example, a firm raising funds with debt today may need raising funds with debt today may need to useto use
equity the next time, and the equity the next time, and the cost of equity will be related to cost of equity will be related to the overall capital structure, including debt, ofthe overall capital structure, including debt, of
the firm at the time.the firm at the time.
2. 2. The cost of capiThe cost of capital provides tal provides a benchmark againsa benchmark against which the pot which the potential rate of rtential rate of return on an investmeturn on an investment isent is
compared. Financial managers should only invest in projects that are compared. Financial managers should only invest in projects that are expected to provide a rate expected to provide a rate of return inof return in
excess of the cost of excess of the cost of capital. Selection of projects with returns in excess of capital. Selection of projects with returns in excess of the cost of capital increases firmthe cost of capital increases firm
value. The selection of all projects with expected revalue. The selection of all projects with expected returns that are equal or turns that are equal or greater to the firmgreater to the firm ’’s cost of capitals cost of capital
maximizes shareholder wealth. Capital budgeting is the process of evaluating and selecting long-termmaximizes shareholder wealth. Capital budgeting is the process of evaluating and selecting long-term
investments that exceed the cost of capital and investments that exceed the cost of capital and thereby maximize shareholder wealth.thereby maximize shareholder wealth.
3.3. Capital structureCapital structure consists of long-term sources of financing, coming from bondholders and  consists of long-term sources of financing, coming from bondholders and stockholders. Thestockholders. The
cost of each source cost of each source of financing is weighted by the proportion of long-term funds that of financing is weighted by the proportion of long-term funds that come from that sourcecome from that source
of financing. The long-run average amount of of financing. The long-run average amount of financing from each of these sources represents the financing from each of these sources represents the targettarget
capital structure. When the cost of capital structure. When the cost of each source of financing is multiplied by the each source of financing is multiplied by the proportionate amount in theproportionate amount in the
capital structure, the aggregate is the firmcapital structure, the aggregate is the firm ’’s weighted average cost of s weighted average cost of capital. Ultimately, it is the marginal, orcapital. Ultimately, it is the marginal, or
incremental, cost of capital necessary to raise incremental, cost of capital necessary to raise the next marginal dollar of financing that is relevant the next marginal dollar of financing that is relevant for makingfor making
investment decisions.investment decisions.
4.4. The four basic lonThe four basic long-term sources og-term sources of capital available f capital available to firms are long-to firms are long-term debt, preferred stockterm debt, preferred stock, common, common
stock, and retained earnings. Common stock refers to stock, and retained earnings. Common stock refers to the amount obtained by the firm through the issuance ofthe amount obtained by the firm through the issuance of
shares, either in an initial public offering or shares, either in an initial public offering or subsequent stock sale.subsequent stock sale.
The use of the weighted average cost of capital is recommended over the cost of the source of funds to beThe use of the weighted average cost of capital is recommended over the cost of the source of funds to be
used for the project. The used for the project. The interrelatedness of financing decisions assuming the presence of a target capitalinterrelatedness of financing decisions assuming the presence of a target capital
structure is reflected in the weighted average cost of structure is reflected in the weighted average cost of capital.capital.
5. The5. The net proceedsnet proceeds from the sale of a bond are the funds received from its sale after all underwriting and from the sale of a bond are the funds received from its sale after all underwriting and
 brokerage fees have been paid. A bond s brokerage fees have been paid. A bond sells at a discount when ells at a discount when the rate of interest currentthe rate of interest currently paid on similar-ly paid on similar-
risk bonds is above the bondrisk bonds is above the bond ’’s coupon rate. Bonds sell at s coupon rate. Bonds sell at a premium when their coupon rate a premium when their coupon rate is above theis above the
 prevailing market rate of in prevailing market rate of interest on similar-risk bondsterest on similar-risk bonds..
 Flotation co Flotation costssts are fees  are fees charged by investment banking firms for their services in assisting in selling thecharged by investment banking firms for their services in assisting in selling the
 bonds in the primary market. Thes bonds in the primary market. These costs reduce the total pe costs reduce the total proceeds received by the firm because the fees areroceeds received by the firm because the fees are
 paid from the bond funds. paid from the bond funds.
6. 6. The three appThe three approaches to roaches to finding thfinding the before-tax cost e before-tax cost of debt of debt are the followare the following:ing:
a. Thea. The quotation approachquotation approach that uses the current market  that uses the current market value of a value of a bond to determine the yield-to-maturitbond to determine the yield-to-maturityy
on the bond. If the market price of the bond is equal to its par value the yield-to-maturity is the same as theon the bond. If the market price of the bond is equal to its par value the yield-to-maturity is the same as the
coupon rate.coupon rate.
 b.  b. TheThe calculation approachcalculation approach finds the before-tax cost of debt finds the before-tax cost of debt by calculating the internal rate of return (IRR)by calculating the internal rate of return (IRR)
of the bondof the bond’’s cash flows.s cash flows.
c. Thec. The approximation approachapproximation approach uses the following formula to approximate the before-tax cost uses the following formula to approximate the before-tax cost of the debt.of the debt.
180 Gitman/Zutter180 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
[[(($$11, 0, 0000 0 ))]]
( ( $$11, 0, 00000))
22
d d 
d d 
d d 
 N  N 
 I  I 
nn
r r 
 N  N 




where:where:  I  I   the annual interest payment in dollarsthe annual interest payment in dollars
 N  N d d   the net proceeds from the sale of a bondthe net proceeds from the sale of a bond
nn  the term of the bond in yearsthe term of the bond in years
The first part of the The first part of the numerator of the equation represents the annual interest, and the numerator of the equation represents the annual interest, and the second partsecond part
represents the amortization of any discount or premium; the represents the amortization of any discount or premium; the denominator represents the average amountdenominator represents the average amount
 borrowed. borrowed.
7. 7. The before-tax The before-tax cost is cost is converted to converted to an after-tax an after-tax debt codebt cost (st (r r ii) by using the following equation:) by using the following equation:
r r ii  r r d d  (1 (1  T T ), where), where T T  is the firm is the firm’’s tax rate.s tax rate.
8. 8. Answers will Answers will vary for quvary for question becauestion because values ase values are algorithmicalre algorithmically generated ly generated in MyFinanceLabin MyFinanceLab..
9. 9. The cost of preferred The cost of preferred stock is found stock is found by dividinby dividing the annual pg the annual preferred stock divreferred stock dividend by the neidend by the net proceeds fromt proceeds from
the sale of the preferred stock. The formula is:the sale of the preferred stock. The formula is:
 p p
 p p
 p p
 D D
r r 
 N  N 

where:where:  D D p p  the annual dividend payment in dollars the annual dividend payment in dollars
 N  N  p p  the net proceeds from the sale of the preferred stock the net proceeds from the sale of the preferred stock
10. 10. The assumptions underlying the constant-growtThe assumptions underlying the constant-growth valuation (Gordon) model areh valuation (Gordon) model are
a. a. The The value value of of a a share share of of stock stock is is thethe PV  PV  of all dividends expected to  of all dividends expected to be paid over its life.be paid over its life.
 b.  b. The rate of growth of divThe rate of growth of dividends and earnings is idends and earnings is constant, which means that constant, which means that the firm has athe firm has a  fixed payo fixed payoutut
ratio.ratio.
c. c. Firms perceived Firms perceived by investby investors to bors to be equally e equally risky havrisky have their expecte their expected earnings ed earnings discounted discounted at the samat the same rate.e rate.
11. 11. The CAThe CAPM technPM technique ique directly directly considers considers a fa firmirm’’s risk, through the inclusion ofs risk, through the inclusion of ““ beta, beta,”” in determining the in determining the
required rate of return required rate of return on common stockholders. By contrast, the constant-growth model uses the marketon common stockholders. By contrast, the constant-growth model uses the market
 price in the denominator. T price in the denominator. This price is an indicatiohis price is an indication of the expectations of invn of the expectations of investors in the marketplaceestors in the marketplace
regarding risk and return.regarding risk and return.
12. 12. The cost of retainThe cost of retained earnings ed earnings is technically leis technically less than the cosss than the cost of new commt of new common stock because by on stock because by using retainedusing retained
earnings (cash) the firm avoids underwriting costs, as well aearnings (cash) the firm avoids underwriting costs, as well as possible underpricing costs.s possible underpricing costs.
13. The13. The weighted average cost of capital weighted average cost of capital  ( (WACC WACC ),), r r aa, is an average of the firm, is an average of the firm’’s cost of long-term financing. It iss cost of long-term financing. It is
calculated by weighting the cost of each calculated by weighting the cost of each specific type of capital by its proportion in the firmspecific type of capital by its proportion in the firm ’’s capitals capital
structure. The weights must be nonnegative and sum to structure. The weights must be nonnegative and sum to 1.0.1.0.
14. The14. The weighted average cost of capital weightedaverage cost of capital  ( (WACC WACC ),), r r aa, is highly dependent upon the firm, is highly dependent upon the firm’’s target capital structure.s target capital structure.
As the proportion of financing arising from a As the proportion of financing arising from a specific source rises, the importance of specific source rises, the importance of the cost of that source ofthe cost of that source of
financing rises also. Initially projects are funded with retained earnings, which is cheaper financing rises also. Initially projects are funded with retained earnings, which is cheaper because it does notbecause it does not
include a floatation cost. However, as the include a floatation cost. However, as the amount of funding from common stockholders rises, the firm isamount of funding from common stockholders rises, the firm is
more likely to require external financing. The cmore likely to require external financing. The common stockholdersommon stockholders’’ portion of the weighted average cost of portion of the weighted average cost of
capital will either come from retained capital will either come from retained earnings or external financing, not both.earnings or external financing, not both.
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 181181
15. Using15. Using target capital structure weightstarget capital structure weights, a firm is trying to develop a capital structure that is optimal for the, a firm is trying to develop a capital structure that is optimal for the
future, given present investor attitudes toward financial risk. Target capital structure weights are most oftenfuture, given present investor attitudes toward financial risk. Target capital structure weights are most often
 based on desired changes in  based on desired changes in historical book historical book value weights. Unless sivalue weights. Unless significant changes are imgnificant changes are implied by theplied by the
target capital structure weights, little difference in the weighted marginal cost of capital results from target capital structure weights, little difference in the weighted marginal cost of capital results from their use.their use.
Suggested Answer toSuggested Answer to Focus Focus on on EE tthicshics  Box: The Ethics of Profit Box: The Ethics of Profit
The Vioxx recall increased Merck’s cost of capital. What effect would an inThe Vioxx recall increased Merck’s cost of capital. What effect would an increased cost of capital have on acreased cost of capital have on a
firm’s future investments?firm’s future investments?
For an investment to be worthwhile for a firm, the expected return must be greater than the cost of capital. When aFor an investment to be worthwhile for a firm, the expected return must be greater than the cost of capital. When a
firm’s cost of capital increases, it has the potential to make investment oppor firm’s cost of capital increases, it has the potential to make investment oppor tunities that once appeared attractivetunities that once appeared attractive
to the firm suddenly unattractive.to the firm suddenly unattractive.
Suggested Answer toSuggested Answer to Focus Focus on on PPraractcticeice Box: Uncertain Times Make for Box: Uncertain Times Make for
an Uncertain Weighted Average Cost of Capitalan Uncertain Weighted Average Cost of Capital
Why donWhy don’’t firms generally use both short- and long-run weighted average costs of capital?t firms generally use both short- and long-run weighted average costs of capital?
Firms maximize shareholder wealth through investment in fixed assets. Capital budgeting is the Firms maximize shareholder wealth through investment in fixed assets. Capital budgeting is the process ofprocess of
evaluating and selecting these assets, which are utilized for evaluating and selecting these assets, which are utilized for more than a year. more than a year. Mismatching of asset life andMismatching of asset life and
financing duration increases financial risk.financing duration increases financial risk.
Short-term borrowing is frequently cheaper than long-term sources of Short-term borrowing is frequently cheaper than long-term sources of funding because the short-term lenderfunding because the short-term lender
knows that the long-term sources of caknows that the long-term sources of capital back up the loan. This box pital back up the loan. This box reports that Caraustar uses both a short-termreports that Caraustar uses both a short-term
and long-term cost of capital, and long-term cost of capital, which rises with the length of the debt which rises with the length of the debt used in estimating the cost of used in estimating the cost of capital. From ancapital. From an
operational standpoint, this would be difficult because short-term rates are quite volatile. Hence, operational standpoint, this would be difficult because short-term rates are quite volatile. Hence, projects that areprojects that are
unacceptable one month might be acceptable the unacceptable one month might be acceptable the next. The financial manager would have to update anext. The financial manager would have to update andnd
disseminate information on the current short-term cost of capital.disseminate information on the current short-term cost of capital.
Another reason most companies do not operate with a Another reason most companies do not operate with a short-term and long-term cost of capital is short-term and long-term cost of capital is that debt is only athat debt is only a
fraction (and in many companies a small fraction) of the financing. Also, to be accurate, one would have tofraction (and in many companies a small fraction) of the financing. Also, to be accurate, one would have to
consider the fact that stockholders would increase their required rate consider the fact that stockholders would increase their required rate of return if they were of return if they were aware that the debtaware that the debt
 being used was short-t being used was short-term because loan expiration occurs merm because loan expiration occurs more quickly, short-term interest rates aore quickly, short-term interest rates are more volatilere more volatile
and could be higher, and the company may find it difficult to find a lender. Hence, the advantage of using short-and could be higher, and the company may find it difficult to find a lender. Hence, the advantage of using short-
term debt in a WACC may not be as term debt in a WACC may not be as dramatic as observed by Mr. Domanico. One should consider financiadramatic as observed by Mr. Domanico. One should consider financiall
interrelationships over the long run.interrelationships over the long run.
Answers to Warm-Up ExercisesAnswers to Warm-Up Exercises
E9-1. E9-1. Weighted Weighted average average cost cost of of capitalcapital
Answer:Answer: NN  10, PV 10, PV  $20,000 (1 $20,000 (1  0.02)0.02)  $19,600, PMT $19,600, PMT  0.080.08  $20,000 $20,000  $1,600, FV$1,600, FV  $20,000$20,000
Solve for ISolve for I  8.30%8.30%
E9-2. E9-2. Cost Cost of of preferred preferred stockstock
Answer:Answer: The cost oThe cost of preferred stock f preferred stock is the ratis the ratio of the io of the preferred stock preferred stock dividend to dividend to the firmthe firm’’s net proceeds froms net proceeds from
the sale of the preferred stock.the sale of the preferred stock.
r r  p p  D D p p  N  N  p p
r r  p p  (0.15 (0.15  $35) $35)  ($35 ($35  $3) $3)
182 Gitman/Zutter182 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
r r  p p  $5.25 $5.25  $32 $32  16.4% 16.4%
E9-3. E9-3. Cost Cost of of common common stock stock equityequity
Answer:Answer: The cost of commThe cost of common stock equity on stock equity can be found by can be found by dividing the ddividing the dividend expected ividend expected at the end of yat the end of year 1ear 1
 by the current price of the stock  by the current price of thestock and adding the expected gand adding the expected growth rate.rowth rate.
r r  s s  ( ( D D11  P  P 00))  g  g 
r r  s s  ($6.50 ($6.50  $78) $78)  7% 7%  15.33% 15.33%
E9-4. E9-4. Weighted Weighted average average cost cost of of capitalcapital
Answer:Answer: r r aa        (0.35(0.35  0.08) 0.08)  (0.65 (0.65  0.13) 0.13)  0.0280 0.0280  0.0845 0.0845  11.25% 11.25%
E9-5. E9-5. Weighted Weighted average average cost cost of of capitalcapital
Answer:Answer: r r aa  (0.55 (0.55  0.067) 0.067)  (0.10 (0.10  0.092) 0.092)  (0.35 (0.35  0.106) 0.106)  0.0832 0.0832  8.32% 8.32%
Solutions to ProblemsSolutions to Problems
P9-1. P9-1. Concept Concept of of cost cost of of capitalcapital
LG 1; BasicLG 1; Basic
a. a. Project North Project North is expected is expected to earn to earn an 8% an 8% return. If return. If the analythe analyst expects st expects the cost the cost of debt of debt to be to be 7%, he7%, he
will probably recommend the project be accepted because will probably recommend the project be accepted because expected return is greater than the cost expected return is greater than the cost ofof
debt.debt.
 b.  b. Project South is expected to Project South is expected to earn 15%, but if the analyst believearn 15%, but if the analyst believes that it will be finaes that it will be financed with equitynced with equity
that costs 16%, the analyst will likely recommend that the that costs 16%, the analyst will likely recommend that the firm reject the project because firm reject the project because thethe
expected return (15%) is less than the cost of debt (16%).expected return (15%) is less than the cost of debt (16%).
c. c. These These decisions decisions may may not not be be in in the the best best interest interest of of a fa firmirm’’s investors because the firm uses a blend ofs investors because the firm uses a blend of
debt and equity to finance its investments, so the proper “hurdle rate” for investment opportunitiesdebt and equity to finance its investments, so the proper “hurdle rate” for investment opportunities
ought to reflect the cost of the blend, not the cost of debt or equity alone.ought to reflect the cost of the blend, not the cost of debt or equity alone.
d. d. The The weighted weighted average average cost cost is is (0.4(0.4 ×× 7%) + (0.6 7%) + (0.6 ×× 16%) = 12.4%. 16%) = 12.4%.
e. e. If both If both analysts analysts used 1used 12.4% as 2.4% as the huthe hurdle rate rdle rate for the for the investments, investments, then Nthen North woorth would uld be rejected, be rejected, andand
South would be accepted.South would be accepted.
f. f. When the When the analysts analysts focus ofocus on a n a single single source osource of financf financing ing rather than rather than the blthe blend that end that the firm the firm actuallyactually
uses, then they make exactly the uses, then they make exactly the wrong recommendations, accepting North when it should bewrong recommendations, accepting North when it should be
rejected, and rejecting South when it rejected, and rejecting South when it should be accepted.should be accepted.
P9-2. P9-2. Cost Cost of of debt debt using using both both methodsmethods
LG 3; IntermediateLG 3; Intermediate
a. a. Net Net proceeds:proceeds: N  N d d  $1,010 $1,010  $30 $30
 N  N d d  $980$980
 b.  b. Cash flows:Cash flows: T CFT CF
0 0 $ $ 980980
11 –  – 1515 120120
1515 1,0001,000
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 183183
c. c. Cost Cost to to maturity:maturity:
 N N  15, PV 15, PV  980, PMT 980, PMT  120, FV120, FV  1,0001,000
Solve for I: 12.30%Solve for I: 12.30%
After-tax cost: 12.30% (1After-tax cost: 12.30% (1  0.4) 0.4)  7.38% 7.38%
d. d. Approximate Approximate before-tax before-tax cost cost of of debtdebt
($1($1,000 ,000 $98$980)0)
$120$120
1515
($9($980 80 $1$1,000),000)
22
d d r r 




r r d d  $121.33 $121.33  $990 $990
r r d d  12.26% 12.26%
Approximate after-tax cost of debtApproximate after-tax cost of debt  12.26% 12.26%  (1 (1   0.4)0.4)  7.36% 7.36%
e. e. The advThe advantages antages of tof the calhe calculator culator method method are evare evident. ident. There are There are fewer kfewer keypunching eypunching strokes, and strokes, and oneone
gets the actual cost of gets the actual cost of debt financing. However, the approximation formula is fairly accurate anddebt financing. However, the approximation formula is fairly accurate and
expedient in the absence of a expedient in the absence of a financial calculator.financial calculator.
P9-3. P9-3. Before-tax Before-tax cost cost of of debt debt and and after-tax after-tax cost cost of of debtdebt
LG 3; EasyLG 3; Easy
a. Na. N  10, PV 10, PV   930 (an expenditure), PMT 930 (an expenditure), PMT  0.6(1,000) 0.6(1,000)  60, FV 60, FV  1,000 1,000
Solving for ISolving for I  7.00% 7.00%
 b.  b. Use the model: After-tax cost oUse the model: After-tax cost of debtf debt  before-tax cost of debt before-tax cost of debt  (1 (1  tax bracket) tax bracket)
7.0% (17.0% (1  0.2) 0.2)  5.6% 5.6%
P9-4. P9-4. Cost Cost of of debt debt using using the the approximation approximation formula:formula:
LG 3; BasicLG 3; Basic
$1,000$1,000
$1,000$1,000
22
d d 
d d 
d d 
 N  N 
 I  I 
nnr r 
 N  N 




r r ii  r r d d  (1 (1   T T ))
Bond ABond A
$1$1,000 ,000 $9$95555
$90$90
$92.25$92.252020 9.44%9.44%
$9$955 55 $1$1,000,000   $977.50  $977.50
22
d d 
r r 


    

r r ii  9.44% 9.44%  (1 (1   0.40)0.40)  5.66% 5.66%
Bond BBond B
$1$1,000 ,000 $9$97070
$100$100
$101.88$101.881616 10.34%10.34%
$9$970 70 $1$1,000,000   $985  $985
22
d d 
r r 


    

r r ii  10.34% 10.34%  (1 (1   0.40)0.40)  6.20% 6.20%
184 Gitman/Zutter184 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
Bond CBond C
$1$1,000 ,000 $9$95555
$120$120
$123$1231515 12.58%12.58%
$9$955 55 $1$1,000,000   $977.50  $977.50
22
d d 
r r 


    

r r ii  12.58% 12.58%  (1 (1   0.40)0.40)  7.55% 7.55%
Bond DBond D
$1$1,000 ,000 $9$98585
$90$90
$90.60$90.602525 9.13%9.13%
$9$985 85 $1$1,000,000   $992.50  $992.50
22
d d 
r r 


    

r r ii  9.13% 9.13%  (1 (1   0.40)0.40)  5.48% 5.48%
Bond EBond E
$1$1,000 ,000 $9$92020
$110$110
$113.64$113.642222 11.84%11.84%
$9$920 20 $1$1,000,000   $960  $960
22
d d 
r r 


    

r r ii  11.84% 11.84%  (1 (1   0.40)0.40)  7.10% 7.10%
P9-5. P9-5. Cost Cost of of debt debt using using the the approximation approximation formulaformula
LG 3; IntermediateLG 3; Intermediate
$1,000$1,000
$1,000$1,000
22
d d 
d d 
d d 
 N  N 
 I  I 
nn
r r 
 N  N 




r r ii  r r dd  (1 (1   T T ))
Alternative AAlternative A
$1$1,000 ,000 $1$1,220,220
$90$90
$76.25$76.251616 6.87%6.87%
$1$1,220 ,220 $1$1,000,000   $1,110  $1,110
22
d d 
r r 


    

r r ii  6.87% 6.87%  (1 (1   0.40)0.40)  4.12% 4.12%
Calculator: NCalculator: N  16, PV 16, PV  $1,220, PMT $1,220, PMT  $90, FV$90, FV  $1,000$1,000
Solve for I: 6.71%Solve for I: 6.71%
After-tax cost of debt: 4.03%After-tax cost of debt: 4.03%
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 185185
Alternative BAlternative B
$1$1,000 ,000 $1$1,, 020020
$70$70
$66.00$66.0055 6.53%6.53%
$1$1,020 ,020 $1$1,000,000   $1,010  $1,010
22
d d 
r r 


    

r r ii  6.53% 6.53%  (1 (1   0.40)0.40)  3.92% 3.92%
Calculator: NCalculator: N  5, PV 5, PV  $1,020, PMT $1,020, PMT  $70, FV$70, FV  $1,000$1,000
Solve for I: 6.52%Solve for I: 6.52%
After-tax cost of debt: 3.91%After-tax cost of debt: 3.91%
Alternative CAlternative C
$1$1,000 ,000 $9$97070
$60$60
$64.29$64.2977 6.53%6.53%
$9$970 70 $1$1,000,000   $985  $985
22
d d 
r r

    

r r ii  6.53% 6.53%  (1 (1   0.40)0.40)  3.92% 3.92%
Calculator: NCalculator: N  7, PV 7, PV  $970, PMT $970, PMT  $60, FV$60, FV  $1,000$1,000
Solve for I: 6.55%Solve for I: 6.55%
After-tax cost of debt: 3.93%After-tax cost of debt: 3.93%
Alternative DAlternative D
$1$1,000 ,000 $8$89595
$50$50
$60.50$60.501010 6.39%6.39%
$89$895 5 $1$1,000,000   $947.50  $947.50
22
d d 
r r 


    

r r ii  6.39% 6.39%  (1 (1   0.40)0.40)  3.83% 3.83%
Calculator: NCalculator: N  10, PV 10, PV  $895, PMT $895, PMT  $50, FV$50, FV  $1,000$1,000
Solve for I: 6.46%Solve for I: 6.46%
After-tax cost of debt: 3.87%After-tax cost of debt: 3.87%
P9-6. P9-6. After-tax After-tax cost cost of of debtdebt
LG 3; IntermediateLG 3; Intermediate
a. a. The after-tax coThe after-tax cost of borst of borrowing from rowing from the motorcycle the motorcycle dealer is dealer is the same as the same as the pretax the pretax cost, 5%.cost, 5%.
 b.  b. The after-tax cost of taking ouThe after-tax cost of taking out the second mortgage is 6% × (1t the second mortgage is 6% × (1 –  –  25%) = 4.5%. 25%) = 4.5%.
c. c. The mortgagThe mortgage loan e loan would cowould cost less st less after taxes after taxes compared to compared to the loan the loan from the from the dealer.dealer.
d. d. If Bella takes If Bella takes out a loout a loan on her an on her home that home that she cannot she cannot repay, she may repay, she may risk losing risk losing her home. Iher home. If shef she
cannot repay the motorcycle loan, the lender may not have a claim against Bellacannot repay the motorcycle loan, the lender may not have a claim against Bella ’’s home and may onlys home and may only
 be able to retake possession  be able to retake possession of the motorcycle.of the motorcycle.
186 Gitman/Zutter186 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
P9-7. P9-7. Cost Cost of of preferred preferred stock:stock: r r  p p  D D p p  N  N  p p
LG 2; BasicLG 2; Basic
a.a.
$12.00$12.00
12.63%12.63%
$95.00$95.00
 p p
r r    
 b. b.
$10.00$10.00
11.11%11.11%
$90.00$90.00
 p p
r r    
P9-8. P9-8. Cost Cost of of preferred preferred stock:stock: r r  p p  D D p p  N  N  p p
LG 4; BasicLG 4; Basic
Preferred Preferred Stock Stock CalculationCalculation
AA r r  p p   $11.00  $11.00  $92.00 $92.00  11.96% 11.96%
BB r r  p p   3.20  3.20   34.50  34.50   9.28%  9.28%
CC r r  p p   5.00  5.00   33.00  33.00  15.15% 15.15%
DD r r  p p   3.00  3.00   24.50  24.50  12.24% 12.24%
EE r r  p p   1.80  1.80   17.50  17.50  10.29% 10.29%
P9-9. P9-9. Cost Cost of of common common stock stock equityequity —  — capital asset pricing model (CAPM)capital asset pricing model (CAPM)
LG 5; IntermediateLG 5; Intermediate
r r  s s  R R F  F  [ [bb  ( (r r mm  R R F  F )])]
r r  s s  6% 6%  1.2 1.2  (11% (11%  6%) 6%)
r r  s s  6% 6%  6% 6%
r r  s s  12% 12%
a. a. Risk Risk premiumpremium  6% 6%
 b.  b. Rate of returnRate of return  12% 12%
c. c. After-tax After-tax cost cost of of common common equity equity using using the the CAPMCAPM  12% 12%
P9-1P9-10. 0. Cost Cost of of common common stock stock equity:equity: 11
nn
 D  D g g 
nn N N 
k k 


LG 5; IntermediateLG 5; Intermediate
a. Na. N  4 (2015 4 (2015  2011), PV (initial value) 2011), PV (initial value)  $2.12, FV (terminal value)$2.12, FV (terminal value)  $3.10 $3.10
Solve for I (growth rate): 9.97%Solve for I (growth rate): 9.97%
 b. b.  N  N nn  $52 (given in the  $52 (given in the problem)problem)
c.c. r r r r  (Next Dividend (Next Dividend  Current Current Price)Price)  growth rate growth rate
r r r r  ($3.40 ($3.40   $57.50)  $57.50)  0.0997 0.0997
r r r r  0.0591 0.0591  0.0997 0.0997  0.1588 or 15.88% 0.1588 or 15.88%
d.d. r r r r  ($3.40 ($3.40  $52) $52)  0.0997 0.0997
r r r r  0.0654 0.0654  0.0997 0.0997  0.1651 or 16.51% 0.1651 or 16.51%
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 187187
P9-11P9-11. . RetaineRetained d earnings earnings versus versus new new common common stockstock
LG 5; IntermediateLG 5; Intermediate
11
00
r r 
 D D
r r g g 
 P  P 
  
11
nn
nn
 D D
r r g g 
 N  N 
  
Firm CalculationFirm Calculation
AA r r r r  ($2.25 ($2.25  $50.00) $50.00)  8% 8%  12.50% 12.50%
r r nn  ($2.25 ($2.25   $47.00)  $47.00)  8%8%  12.79% 12.79%
BB r r r r  ($1.00 ($1.00   $20.00)  $20.00)  4%4%   9.00%  9.00%
r r nn  ($1.00 ($1.00   $18.00)  $18.00)  4%4%   9.56%  9.56%
CC r r r r  ($2.00 ($2.00   $42.50)  $42.50)  6%6%  10.71% 10.71%
r r nn  ($2.00 ($2.00   $39.50)  $39.50)  6%6%  11.06% 11.06%
DD r r r r  ($2.10 ($2.10   $19.00)  $19.00)  2%2%  13.05% 13.05%
r r nn  ($2.10 ($2.10   $16.00)  $16.00)  2%2%  15.13% 15.13%
P9-12P9-12. . Effect of Effect of tax tax rate rate on on WACCWACC
LG 3, 4, 5, 6; LG 3, 4, 5, 6; IntermediateIntermediate
a. WACCa. WACC  (0.40)(6%)(1 (0.40)(6%)(1  0.40) 0.40)  (0.10)(8%) (0.10)(8%)  (0.50)(10%) (0.50)(10%)
WACCWACC  1.44% 1.44%  0.8% 0.8%  5% 5%
WACCWACC  7.24% 7.24%
 b.  b. WACCWACC  (0.40)(6%)(1 (0.40)(6%)(1  0.35) 0.35)  (0.10)(8%) (0.10)(8%)  (0.50)(10%) (0.50)(10%)
WACCWACC  1.56% 1.56%  0.8% 0.8%  5% 5%
WACCWACC  7.36% 7.36%
c. WACCc. WACC  (0.40)(6%)(1 (0.40)(6%)(1  0.25) 0.25)  (0.10)(8%) (0.10)(8%)  (0.50)(10%) (0.50)(10%)
WACCWACC  1.80% 1.80%  0.8% 0.8%  5% 5%
WACCWACC  7.60% 7.60%
d. d. As the As the tax rate tax rate falls, the falls, the weighted-avweighted-average cost oerage cost of capital f capital goes up. goes up. The lowThe lower the er the tax rate, tax rate, the lowerthe lower
the government “subsidy” for debt.the government “subsidy” for debt.
P9-13. WACCP9-13. WACC —  —  book weights book weights
LG 6; BasicLG 6; Basic
a.a.
Type Type of of Capital Capital Book Book Value Value Weight Weight Cost Cost Weighted Weighted CostCost
Long-term Long-term debt debt $700,000 $700,000 0.500 0.500 5.3% 5.3% 2.650%2.650%
Preferred Preferred stock stock 50,000 50,000 0.036 0.036 12.0% 12.0% 0.432%0.432%
Common Common stock stock 650,000 650,000 0.464 0.464 16.0% 16.0% 7.424%7.424%
$1,400,000 $1,400,000 1.000 1.000 10.506%10.506%
 b.  b. The WACC is the rate of return that The WACC is the rate of return that the firm must receive on long-term pthe firm must receive on long-term projects to maintain the valurojects to maintain the valuee
of the firm. The cost of capital can be compared to the return for a of the firm. The cost of capital can be compared to the return for a project to determine whether theproject to determine whether the
 project is acceptable. project is acceptable.
188 Gitman/Zutter188 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
P9-14. WACCP9-14. WACC —  —  book weights and  book weights and market weightsmarket weights
LG 6; IntermediateLG 6; Intermediate
a. a. Book Book value value weights:weights:
Type Type of of Capital Capital Book Book Value Value Weight Weight Cost Cost Weighted Weighted CostCost
Long-term Long-term debt debt $4,000,000 $4,000,000 0.784 0.784 6.00% 6.00% 4.704%4.704%
Preferred Preferred stock stock 40,000 40,000 0.008 0.008 13.00% 13.00% 0.104%0.104%
Common Common stock stock 1,060,000 1,060,000 0.208 0.208 17.00% 17.00% 3.536%3.536%
$5,100,000 8.344%$5,100,000 8.344%
 b.  b. Market value weights:Market value weights:
Type Type of of Capital Capital Market Market Value Value Weight Weight Cost Cost Weighted Weighted CostCost
Long-term Long-term debt debt $3,840,000 $3,840,000 0.557 0.557 6.00% 6.00% 3.342%3.342%
Preferred Preferred stock stock 60,000 60,000 0.009 0.009 13.00% 13.00% 0.117%0.117%
Common Common stock stock 3,000,000 3,000,0000.435 0.435 17.00% 17.00% 7.395%7.395%
$6,900,000 10.854%$6,900,000 10.854%
c. c. The differenThe difference lies ce lies in thin the two e two different different value bvalue bases. The ases. The market vmarket value approach alue approach yields yields the betthe better valueter value
 because the costs of the com because the costs of the components of the capital struponents of the capital structure are calculated using tcture are calculated using the prevailing markethe prevailing market
 prices. Because the common stock is se prices. Because the common stock is selling at a higher vlling at a higher value than its book value, the cosalue than its book value, the cost of capitalt of capital
is much higher when using the is much higher when using the market value weights. Notice that the book value weights give themarket value weights. Notice that the book value weights give the
firm a much greater leverage position than when the market value weights are used.firm a much greater leverage position than when the market value weights are used.
P9-1P9-15. 5. WACC WACC and and target target weightsweights
LG 6; IntermediateLG 6; Intermediate
a. a. Historical Historical market market weights:weights:
Type Type of of Capital Capital Weight Weight Cost Cost Weighted Weighted CostCost
Long-term Long-term debt debt 0.25 0.25 7.20% 7.20% 1.80%1.80%
Preferred Preferred stock stock 0.10 0.10 13.50% 13.50% 1.35%1.35%
Common Common stock stock 0.65 0.65 16.00% 16.00% 10.40%10.40%
13.55%13.55%
 b.  b. Target market weights:Target market weights:
Type Type of of Capital Capital Weight Weight Cost Cost Weighted Weighted CostCost
Long-term Long-term debt debt 0.30 0.30 7.20% 7.20% 2.160%2.160%
Preferred Preferred stock stock 0.15 0.15 13.50% 13.50% 2.025%2.025%
Common Common stock stock 0.55 0.55 16.00% 16.00% 8.800%8.800%
12.985%12.985%
c. c. Using the Using the historical historical weights, weights, the firm the firm has a has a higher coshigher cost of t of capital due capital due to the to the weighting weighting of the of the moremore
expensive common stock component (0.65) versus the target weight of (0.55). expensive common stock component (0.65) versus the target weight of (0.55). This over-weighting inThis over-weighting in
common stock leads to a common stock leads to a smaller proportion of financing coming from the significantly lesssmaller proportion of financing coming from the significantly less
expensive long-term debt and the lower-costing preferred stock.expensive long-term debt and the lower-costing preferred stock.
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 189189
P9-16P9-16. . Cost Cost of of capitalcapital
LG 3, 4, 5, 6; LG 3, 4, 5, 6; ChallengeChallenge
a. a. Cost Cost of of retained retained earningsearnings
$$11..2266((1 1 00..0066) ) $$11..3344
00..006 6 33..3355% % 66% % 99..3355%%
$$4400..000 0 $$4400..0000
r r 
r r 

          
 b.  b. Cost of new common stockCost of new common stock
$$11..2266((1 1 00..0066) ) $$11..3344
00..006 6 44..0066% % 66% % 1100..0066%%
$$4400..000 0 $$77..000 0 $$3333..0000
 s s
r r 

          

c. c. Cost Cost of of preferred preferred stockstock
$$22..000 0 $$22..0000
9.09%9.09%
$2$25.5.00 00 $3$3.0.00 0 $2$22.2.0000
 p p
r r      

d.d.
$1$1,000 ,000 $1$1,175,175
$100$100
$65.00$65.0055 5.98%5.98%
$1$1,175 ,175 $1$1,000,000   $1,087.50  $1,087.50
22
d d 
r r 


    

r r ii  5.98% 5.98%  (1 (1   0.40)0.40)  3.59% 3.59%
e. WACCe. WACC  (0.40)(3.59%)(0.40)(3.59%)  (0.10)(9.09%) (0.10)(9.09%)  (0.50)(9.35%) (0.50)(9.35%)
WACCWACC  1.436 1.436  0.909 0.909  4.675 4.675
WACCWACC  7.02% 7.02%
P9-17P9-17. . CalculatCalculation ion of of individuaindividual l costs, costs, WACC, WACC, and and WMCCWMCC
LG 3, 4, 5, 6; LG 3, 4, 5, 6; ChallengeChallenge
a. a. After-tax After-tax cost cost of of debtdebt
 Approximate  Approximate ApproachApproach
(($$11, 0, 0000 0 ))
( ( $$11, 0, 00000))
22
d d 
d d 
d d 
 N  N 
 I  I 
nn
r r 
 N  N 




($1($1,000 ,000 $95$950)0)
$100$100
$$11000 0 $$551010 10.77%10.77%
($9($950 50 $1$1,000),000)   $975  $975
22
d d 
r r 



    

r r ii  10.77 10.77  (l (l   0.40)0.40)
r r ii  6.46% 6.46%
Calculator approachCalculator approach
 N N  10, PV 10, PV  $950, PMT $950, PMT  $100, FV$100, FV  $1,000$1,000
Solve for I: 10.84%Solve for I: 10.84%
After-tax cost of debt: 10.84 (1After-tax cost of debt: 10.84 (1  0.40) 0.40)  6.51% 6.51%
190 Gitman/Zutter190 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
 b.  b. Cost of preferred stock:Cost of preferred stock:
pp
 p p
 p p
 D D
r r 
 N  N 

$8$8
12.70%12.70%
$63$63
 p p
r r    
c. c. Cost Cost of of new new common common stock stock equity:equity:
Solve for g:Solve for g:
 N N  4, PV 4, PV  $2.85, FV$2.85, FV  $3.75 $3.75
Solve for I: 7.10%Solve for I: 7.10%
 Net Proceeds: Current price Net Proceeds: Current price –  –  Price adjustment Price adjustment –  –  Floatation cost Floatation cost
$50$50  $5 $5  $3 $3  $42 $42
r r nn  $4.00 $4.00  $42.00 $42.00  0.0710 0.0710  0.0952 0.0952  0.0710 0.0710  0.1662 0.1662  $16.62% $16.62%
d. d. WACC: WACC: Long-term Long-term debt 0.40debt 0.40  6.51% 6.51%   2.60%  2.60%
Preferred Preferred stock stock 0.100.10  12.70% 12.70%   1.27%  1.27%
Common Common stock stock 0.500.50  16.62% 16.62%   8.31%  8.31%
WACCWACC  12.18% 12.18%
P9-P9-18. 18. Personal fiPersonal finance pronance problem: Weigblem: Weighted-average hted-average cost of cost of capitalcapital
LG 6; IntermediateLG 6; Intermediate
RateRate
[1][1]
Outstanding Loan BalanceOutstanding Loan Balance
[2][2]
WeightWeight
[2][2] [3][3]
WACCWACC
[1] [3][1] [3]
oan 1oan 1
oan 2oan 2
oan 3oan 3
6.00%6.00%
9.00%9.00%
5.00%5.00%
$ 20,000$ 20,000
$12,000$12,000
$32,000$32,000
31.25%31.25%
18.75%18.75%
50.00%50.00%
1.88%1.88%
1.69%1.69%
2.50%2.50%
otal otal $64,000 $64,000 6.06%6.06%
John Dough should not consolidate his college loans because their weighted cost is less than the John Dough should not consolidate his college loans because their weighted cost is less than the 7.2%7.2%
offered by his bank.offered by his bank.
P9-1P9-19. 9. CalculatCalculation ion of of individual individual costs costs and and WACCWACC
LG 3, 4, 5, 6; LG 3, 4, 5, 6; ChallengeChallenge
a. a. After-tax After-tax cost cost of of debtdebt
 Approximate  Approximate approachapproach
(($$11, 0, 0000 0 ))
( ( $$11, 0, 00000))
22
d d 
d d 
d d 
 N  N 
 I  I 
nn
r r 
 N  N 




($1($1,000 ,000 $94$940)0)
$80$80
$$880 0 $$332020 8.56%8.56%
($9($940 40 $1$1,000),000)   $970  $970
22
d d 
r r 



    

64,000 64,000 
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 191191
r r ii  rd rd  (1 (1   t t ))
r r ii  8.56% 8.56%  (1 (1   0.40)0.40)
r r ii  5.14% 5.14%
Calculator approachCalculator approach
 N N  20, PV 20, PV  $940, PMT $940, PMT  $80, FV$80, FV  $1,000$1,000
Solve for I: 8.64%Solve for I: 8.64%
After-tax cost of debt: 8.64% (1After-tax cost of debt: 8.64% (1 0.40)0.40)  5.18% 5.18%
 b.  b. Preferred stock:Preferred stock:
$7.60$7.60
8.44%8.44%
$90$90
 p p
 p p
 p p
 p p
 D D
r r 
 N  N 
r r 

  
c. c. Retained Retained earnings:earnings:
11
00
= ($7.00 ÷ $90) + 0.06 = 0.0778 + 0.0600= ($7.00 ÷ $90) + 0.06 = 0.0778 + 0.0600 = 0.1378 or 13.78% = 0.1378 or 13.78%
r r 
 D D
r r g g 
 P  P 
  
 New common stock: New common stock:
11
= = [[$$77..000 ÷ 0 ÷ (($$9900 $$77 $$55))] + ] + 00..0066
= [$7.00 ÷ $78] + 0.06 = = [$7.00 ÷ $78] + 0.06 = 0.0897 + 0.06000.0897 + 0.0600 = 0.1497 or 14.97% = 0.1497 or 14.97%
nn
nn
 D D
r r g g 
 N  N 
  
  
Type of CapitalTypeof Capital
TargetTarget
CapitalCapital
Structure %Structure %
Cost ofCost of
CapitalCapital
SourceSource
WeightedWeighted
CostCost
2. 2. With With retained retained earningsearnings
Long-term Long-term debt debt 0.30 0.30 5.18% 5.18% 1.55%1.55%
Preferred Preferred stock stock 0.20 0.20 8.44% 8.44% 1.69%1.69%
Common Common stock stock equity equity 0.50 0.50 13.78% 13.78% 6.89%6.89%
WACCWACC  10.13% 10.13%
3.3. With new common stockWith new common stock
Long-term Long-term debt debt 0.30 5.18% 0.30 5.18% 1.55%1.55%
Preferred Preferred stock stock 0.20 8.44% 0.20 8.44% 1.69%1.69%
Common Common stock stock equity equity 0.50 0.50 14.97% 14.97% 7.48%7.48%
WACCWACC  10.72% 10.72%
P9-20P9-20. . Weighted-aWeighted-average verage cost cost of of capitalcapital
LG 6; IntermediateLG 6; Intermediate
a. WACCa. WACC  0.50 (0.06) 0.50 (0.06)  0.50 (0.12) 0.50 (0.12)  0.03 0.03  0.06 0.06  0.09 or 9.0% 0.09 or 9.0%
 b.  b. WACCWACC  0.70 (0.06) 0.70 (0.06)  0.30 (0.12) 0.30 (0.12)  0.042 0.042  0.036 0.036  0.078 or 7.8% 0.078 or 7.8%
192 Gitman/Zutter192 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
c. c. They are They are affected because, affected because, under the under the revised capirevised capital strutal structure, there cture, there is more is more debt financidebt financing. Bondng. Bond
holders represent a prior, legal claim to holders represent a prior, legal claim to the firmthe firm’’s operating income. A larger interest expense must s operating income. A larger interest expense must bebe
 paid prior to any divid paid prior to any dividend payment. There is also a greateend payment. There is also a greater chance of bankruptcy because tr chance of bankruptcy because the firmhe firm ’’ss
operating income may be insufficiently large to accommodate the larger operating income may be insufficiently large to accommodate the larger interest expense.interest expense.
d. WACCd. WACC  0.70 (0.06) 0.70 (0.06)  0.30 (0.16) 0.30 (0.16)  0.042 0.042  0.048 0.048  0.09, or 9% 0.09, or 9%
e. e. Increasing the percentage Increasing the percentage of debt financing of debt financing increases the risk increases the risk of the company of the company not being not being able to make able to make itsits
interest payments. Bankruptcy would have negative consequences to both bondholders andinterest payments. Bankruptcy would have negative consequences to both bondholders and
stockholders. As shown in part d, if stockholders increase their required rate of return, the cost of capitalstockholders. As shown in part d, if stockholders increase their required rate of return, the cost of capital
may not decline. In fact, if the bondholders required a higher return also, the cost of capital wouldmay not decline. In fact, if the bondholders required a higher return also, the cost of capital would
actually rise in this scenario.actually rise in this scenario.
P9-21. P9-21. Ethics Ethics problemproblem
LG 1; IntermediateLG 1; Intermediate
GEGE’’s long string of good earnings reports made s long string of good earnings reports made the company seem less risky, so the company seem less risky, so itit ’’s cost of capital woulds cost of capital would
 be lower (e.g., the AAA credit rating m be lower (e.g., the AAA credit rating mentioned in the chapter oentioned in the chapter opener is evidence of this). If investopener is evidence of this). If investorsrs
learn that GE is really more risky than it seems, then the cost of capital will go up, and GElearn that GE is really more risky than it seems, then the cost of capital will go up, and GE ’’s value wills value will
fall.fall.
CaseCase
Case studies are available on www.myfinancelab.com.Case studies are available on www.myfinancelab.com.
Making Star ProductsMaking Star Products’’ Financing/Investment Decision Financing/Investment Decision
The Chapter 9 case, The Chapter 9 case, Star Products, is an exercise in Star Products, is an exercise in evaluating the cost of capital and available investmentevaluating the cost of capital and available investment
opportunities. The student must calculate the component costs of financing, long-term debt, preferred opportunities. The student must calculate the component costs of financing, long-term debt, preferred stock, andstock, and
common stock equity; determine the break points associated with each source; and ccommon stock equity; determine the break points associated with each source; and calculate the WACC. Finally,alculate the WACC. Finally,
the student must decide which investments to recommend to Star the student must decide which investments to recommend to Star Products.Products.
a. a. Cost Cost of of financing financing sourcessources
Debt:Debt:
(1) Below $450,000:(1) Below $450,000:
Calculator Method:Calculator Method:
 N N  15, PV 15, PV  $960, PMT$960, PMT  $90, FV $90, FV  $1,000 $1,000
Solve for ISolve for I  9.51% 9.51%
r r ii  r r d d  (1 (1   t t ))
r r ii  9.51 9.51  (1 (1  0.4) 0.4)
r r ii  5.71% 5.71%
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 193193
Approximation Method:Approximation Method:
(($$11, 0, 0000 0 ))
( ( $$11, 0, 00000))
22
d d 
d d 
d d 
 N  N 
 I  I 
nn
r r 
 N  N 




($1($1,000 ,000 $96$960)0)
$90$90
1515
($9($960 60 $1$1,000),000)
22
$92.67$92.67
0.0.090946 46 9.9.4646%%
$980$980
d d 
d d 
r r 
r r 




    
r r ii  r r d d  (1 (1   t t ))
r r ii  9.46 9.46  (1 (1  0.4) 0.4)
r r ii  5.68% 5.68%
(2) Above $450,000:(2) Above $450,000: r r ii  r r d d  (1 (1  t t ))
r r ii  13.0 13.0  (1 (1  0.4) 0.4)
r r ii  7.8% 7.8%
(3) Preferred stock:(3) Preferred stock:
$9.80$9.80
0.10.1508 508 15.15.08%08%
$65$65
 p p
 p  p pp
 p p
 D D
r r r r 
 N  N 
      
Common stock equity:Common stock equity:
(4) $0(4) $0$1,500,000:$1,500,000:
00
$0.96$0.96
0.0.11 11 1919%%
$12$12
ii
r r 
r r 
 D D
r r g g 
 P  P 
r r 
  
    
(5) Above $1,500,000:(5) Above $1,500,000:
$0.96$0.96
0.0.11 11 2121.6.67%7%
$9$9
ii
r r 
nn
r r 
 D D
r r g g 
 N  N 
r r 
  
    
194 Gitman/Zutter194 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
 b.  b. Weighted average cost of capiWeighted average cost of capital:tal:
Type of CapitalType of Capital
TargetTarget
CapitalCapital
Structure %Structure %
Cost ofCost of
CapitalCapital
SourceSource
WeightedWeighted
CostCost
1. 1. Long-term Long-term debt debt less less than than $450,001 $450,001 and and common common equity equity less less than than $500,001:$500,001:
Long-term Long-term debt debt 0.30 0.30 5.7% 5.7% 1.71%1.71%
Preferred Preferred stock stock 0.10 0.10 15.1% 15.1% 1.51%1.51%
Common Common stock stock equity equity 0.60 0.60 19.0% 19.0% 11.40%11.40%
1.00 WACC1.00 WACC  14.62% 14.62%
2. 2. Long-term Long-term debt debt greater greater than than $450,000 $450,000 and and common common equity equity less less than than $1,500,00:$1,500,00:
Long-term Long-term debt debt 0.30 0.30 7.8% 7.8% 2.34%2.34%
Preferred Preferred stock stock 0.10 0.10 15.1% 15.1% 1.51%1.51%
Common Common stock stock equity equity 0.60 0.60 19.0% 19.0% 11.40%11.40%
1.00 WACC1.00 WACC  15.25% 15.25%
3. 3. Long-term Long-term debt debt greater greater than than $450,000 $450,000 and and common common equity equity more more thanthan
$1,500,000:$1,500,000:
Long-term Long-term debt debt 0.30 0.30 7.8% 7.8% 2.34%2.34%
Preferred Preferred stock stock 0.10 0.10 15.1% 15.1% 1.51%1.51%
Common Common stock stock equity equity 0.60 0.60 21.7% 21.7% 13.02%13.02%
1.00 WACC1.00 WACC  16.87% 16.87%
c. c. Break Break pointspoints
Long-term debtLong-term debt
common equitycommon equity
Break pointBreak point
$450,000$450,000
((11) ) BBPP $$11,,550000,,000000
0.300.30
$1,500,000$1,500,000((22) ) BBPP $$22,,550000,,000000
0.600.60
 AF  AF 
W W 

  
  
(3) (3) Based on the information above, cheaper debt financing is exhausted when the valueBased on the information above, cheaper debt financing is exhausted when the value
of projects accepted exceeds $1,500,000. Retained earnings can finance $2,500,000 of newof projects accepted exceeds $1,500,000. Retained earnings can finance $2,500,000 of new
 projects without hav projects without having to issue addiing to issue additional debt. In the prior calctional debt. In the prior calculation of weighted avulation of weighted average costserage costs
of capital, a weighted average costs of capital, a weighted average costs of capital for cheap debt and of capital for cheap debt and external equity financing wasexternal equity financing was
not needed because Star Products runs out not needed because Star Products runs out of financing from cheap debt first.of financing from cheap debt first.
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 195195
d. d. Investments Investments are ranked are ranked in terms in terms of their of their rate of rate of return. The return. The project wiproject with the th the highest highest rate of retrate of return is urn is Project C,Project C,
which yields 25%. Project Gwhich yields 25%. Project G’’s 14% rate of return is the worst. The diagram on the next page depicts thes 14% rate of return is the worst. The diagram on the next page depicts the
ranking of projects and includes the weighted marginal costs of ranking of projects and includes the weighted marginal costs of capital. The jumps in the WMCC capital. The jumps in the WMCC occur atoccur at
 break points where a cheaper source of fi break points where a cheaper source of financing is exhausted.nancing is exhausted.
e. e. (1) Cheap (1) Cheap debt debt and and equityequity
The first break point exists when Star The first break point exists when Star Products has used all $450,000 in 9% debt. Assuming that Products has used all $450,000 in 9% debt. Assuming that a morea more
costly source of debt financing is not available, the costly source of debt financing is not available, the firm would accept projects C, firm would accept projects C, D, and B.D, and B.
(2) (2) Cheap debt and Cheap debt and half as much half as much retained earningsretained earnings
If Star Products only had If Star Products only had $750,000 in common stock equity available, its equity break point would be$750,000 in common stock equity available, its equity break point would be
$1,250,000 ($750,000$1,250,000 ($750,000  0.6). This amount is  0.6). This amount is still sufficient to financeProjects C, D, and still sufficient to financeProjects C, D, and B, which combinedB, which combined
have a cost of $1,300,000.have a cost of $1,300,000.
(3) (3) Cheap debt and all $1,50Cheap debt and all $1,500,000 of retained earning0,000 of retained earnings (illustrated in Part d)s (illustrated in Part d)
If Star Products can If Star Products can acquire $1,500,000 in common equity, it can finance acquire $1,500,000 in common equity, it can finance $2,500,000 of new projects. This$2,500,000 of new projects. This
allows it to add Projects F and E. The return on Projects A and G is not sufficient to allow acceptance of theseallows it to add Projects F and E. The return on Projects A and G is not sufficient to allow acceptance of these
 projects. projects.
(4) (4) Limited total Limited total debt and $1,50debt and $1,500,000 of retained 0,000 of retained earningsearnings
If Star Products is If Star Products is limited by access to only a limited by access to only a $1,000,000 of long-term debt, its break point $1,000,000 of long-term debt, its break point would bewould be
$3,333,333 ($1,000,000$3,333,333 ($1,000,000  0.3). The one  0.3). The one million dollar amount would be sufficient to finance all projects,million dollar amount would be sufficient to finance all projects,
which in total cost $3,300,000, if their returns were which in total cost $3,300,000, if their returns were sufficient. As stated above, the returns on project A sufficient. As stated above, the returns on project A and Gand G
are less than the are less than the weighted marginal cost of capital and will be rejected.weighted marginal cost of capital and will be rejected.
Spreadsheet ExerciseSpreadsheet Exercise
The answer to Chapter 9The answer to Chapter 9’’s measurement of the cost s measurement of the cost of capital at Nova Corporation spreadsheet problem is of capital at Nova Corporation spreadsheet problem is locatlocateded
on the Instructor on the Instructor ’’s Resource Center ats Resource Center at www.pearsonhighered.com/ircwww.pearsonhighered.com/ircunder the Instructor under the Instructor ’’s Manual.s Manual.
196 Gitman/Zutter196 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition
Group ExerciseGroup Exercise
Group exercises are available on www.myfinancelab.com.Group exercises are available on www.myfinancelab.com.
Accurately measuring the cost of capital is the Accurately measuring the cost of capital is the topic of this chapter. The group exercise will use topic of this chapter. The group exercise will use currentcurrent
information from the shadow firm to provide details information from the shadow firm to provide details for each groupfor each group ’’s fictitious firm. The balance sheet is s fictitious firm. The balance sheet is thethe
source of this information and the assignment begins with an investigation into the shadow firmsource of this information and the assignment begins with an investigation into the shadow firm ’’s debt/equity mix.s debt/equity mix.
The group uses the shadow firmThe group uses the shadow firm ’’s balance sheet as a s balance sheet as a guide to developing a balance sheet for their guide to developing a balance sheet for their fictitious firm.fictitious firm.
Students should closely follow the sources and uses of the shadow firmStudents should closely follow the sources and uses of the shadow firm ’’s financing. Using this balance sheet thes financing. Using this balance sheet the
WACC is then estimated. Finally, the WACC is then estimated. Finally, the group identifies a new project, identifies its IRR, and compares group identifies a new project, identifies its IRR, and compares it to theit to the
estimated WACC in order to determine whether estimated WACC in order to determine whether the new project should be accepted. One alternative is the new project should be accepted. One alternative is for thefor the
instructor to identify a series of projects and instructor to identify a series of projects and their cash flows, requiring students to determine the acceptability oftheir cash flows, requiring students to determine the acceptability of
each given the estimated WACC.each given the estimated WACC.
Integrative Case 4: Eco Plastics CompanyIntegrative Case 4: Eco Plastics Company
This case focuses on determination of the cThis case focuses on determination of the cost of capital for a fost of capital for a f irm. The student determines the cost of irm. The student determines the cost of individualindividual
sources of financing, including long-term debt, preferred stock, and common stock. sources of financing, including long-term debt, preferred stock, and common stock. The cost of debt The cost of debt is adjusted foris adjusted for
Eco PlasticsEco Plastics’’ 40% tax bracket. The  40% tax bracket. The company is considering a new financial structure, with the rcompany is considering a new financial structure, with the replacement ofeplacement of
 preferred stock financing wi preferred stock financing with debt financing. Addith debt financing. Additional use of debt intional use of debt increases the common stockholdcreases the common stockholdersers ’’ required required
rate of return. The rate of return. The student is asked to compare thetwo student is asked to compare the two weighted average costs of capital and identify the betterweighted average costs of capital and identify the better
financial structure for Eco Plastics Company.financial structure for Eco Plastics Company.
a. a. Cost Cost of of debt:debt:
Proceeds from sale of Proceeds from sale of $1,000 par value bond:$1,000 par value bond:
$1,000$1,000  (average discount & floatation costs) (average discount & floatation costs)
$1,000$1,000  ($45 ($45  $32) $32)  $923 $923
Subsequent payments: Interest payments ($1,000Subsequent payments: Interest payments ($1,000  0.105) 0.105)  Par value Par value
Before-tax cost of debtBefore-tax cost of debt
 N N  20, PV 20, PV  $923, PMT $923, PMT  105, FV105, FV  1,0001,000
Solve for ISolve for I  11.50% 11.50%
After-tax cost of debt:After-tax cost of debt: r r ii  r r d d  (1 (1−−T T ))
11.5% (111.5% (10.4)0.4)  6.9% 6.9%
 b.  b. Cost of preferred stock:Cost of preferred stock: r r  p p  D D p p  N  N  p p
 (0.095 (0.095  $95) $95)  ($95 ($95 −− $7) $7)
 $8.55 $8.55  $88 $88
 9.72% 9.72%
c. c. Cost Cost of of common common stock:stock: r r  j j  R R F  F  [ [bb j j  ( (r r mm  R R F  F )])]
 0.04 0.04  [1.3 [1.3  (0.13 (0.13  0.04)] 0.04)]
 0.04 0.04  [1.3 [1.3  0.09] 0.09]
 0.04 0.04  0.1170 0.1170
 15.7% 15.7%
Chapter Chapter 9 9 The The Cost Cost of of Capital Capital 197197
d. d. Weighted Weighted average average cost cost of of capital:capital: r r aa  ( (wwii  r r ii))  ( (ww p p  r r  p p))  ( (ww s s  r r nn))
 (0.30 (0.30  0.069) 0.069)  (0.20 (0.20  0.0972) 0.0972)  (0.50 (0.50  0.157) 0.157)
 0.0207 0.0207  0.0194 0.0194  0.785 0.785
 0.1186, or about 12% 0.1186, or about 12%
e. e. 1. 1. Change Change in in risk risk Premium:Premium:
Change in betaChange in beta  market risk premium market risk premium
 (1.5 (1.5  1.3) 1.3)  (0.13 (0.13  0.04) 0.04)
 0.2 0.2  0.09 0.09  0.018 0.018
Shareholders require 1.8% more per yearShareholders require 1.8% more per year
 New cost of common equity New cost of common equity:: r r  j j  R R F  F  [[bb j j  (r  (r mm  R R F  F )])]
 0.04 0.04  [1.5 [1.5  (0.13 (0.13  0.04)] 0.04)]
 0.04 0.04  [1.5 [1.5  0.09] 0.09]
 0.04 0.04  0.1350 0.1350
 17.5% 17.5%
 Note: 17.5% Note: 17.5%  15.7% 15.7%  1.8% 1.8%
2. 2. Revised Revised weighted weighted average average cost cost of of capital:capital: r r aa  ((wwii x r  x r ii))  ( (ww s s x r  x r nn))
 (0.50 (0.50  0.069) 0.069)  (0.50 (0.50  0.175) 0.175)
 0.0345 0.0345  0.0875 0.0875
 0.1220 0.1220
3. 3. Eco Eco PlasticsPlastics’’ CFO should retain the c CFO should retain the cheaper current financial structure. Replacing preferred stockheaper current financial structure. Replacing preferred stock
financing with debt financing results in more rfinancing with debt financing results in more risk to the stockholders. The increase in isk to the stockholders. The increase in stockholdersstockholders ’’ required required
rate of return more rate of return more than offsets the advantage of using the low than offsets the advantage of using the low cost debt. If Eco cost debt. If Eco PlasticsPlastics’’ CFO were to CFO were to
revise the capital structure, share price revise the capital structure, share price would fall and shareholder wealth would not be maximized.would fall and shareholder wealth would not be maximized.
 M Moorre e ddoowwnlnlooaad d links:links:
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198 Gitman/Zutter198 Gitman/Zutter •• Principles of Principles of Managerial FinanceManagerial Finance,, Fourteenth Fourteenth EditionEdition