„ Solutions to Problems

P10-1. LG 1: Concept of cost of capital

Basic
a. The firm is basing its decision on the cost to finance a particular project rather than the firm’s
combined cost of capital. This decision-making method may lead to erroneous accept/reject
decisions.
b. ra = wd rd + were
ra = 0.04(7%)+0.60(16%)
ra = 2.8% + 9.6%
ra = 12.4%
c. Reject project 263. Accept project 264.
d. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as
a criterion provides better decisions because it takes into consideration the long-run
interrelationship of financing decisions.
 Chapter 10 The Cost of Capital 3

P10-2. LG 2: Cost of debt using both methods

Intermediate
a. Net proceeds: N d = $1,010 − $30

N d = $980

b.
Cash flows: T CF
0 $ 980
1–15 −120
15 −1,000

c. Cost to maturity:

⎡ n I ⎤ ⎡ M ⎤
B0 = ⎢ ∑ t ⎥
+⎢ n ⎥
⎣ t =1 (1 + r ) ⎦ ⎣ (1 + r ) ⎦
⎡ 15 −$120 ⎤ ⎡ −$1,000 ⎤
$980 = ⎢ ∑ t ⎥
+⎢ 15 ⎥
⎣ t =1 (1 + r ) ⎦ ⎣ (1 + r ) ⎦
Step 1: Try 12%
V = 120 × (6.811) + 1,000 × (0.183)
V = 817.32 + 183
V = $1,000.32

(Due to rounding of the PVIF table values, the value of the bond is 32 cents greater than
expected. At the coupon rate, the value of a $1,000 face value bond is $1,000.)
Try 13%:
V = 120 × (6.462) + 1,000 × (0.160)
V = 775.44 + 160
V = $935.44
The cost to maturity is between 12% and 13%.
Step 2: $1,000.32 − $935.44 = $64.88
Step 3: $1,000.32 − $980.00 = $20.32
Step 4: $20.32 ÷ $64.88 = 0.31
Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt
12.31(1 − 0.40) = 7.39% = after-tax cost of debt
Calculator solution: 12.30%
4 Gitman • Principles of Managerial Finance, Brief Fifth Edition

d. Approximate before-tax cost of debt

$1,000 − N d
rd = n
N d + $1,000
2
($1,000 − $980) $1,000 − N d
$120 + I+
rd = 15 rd = n
($980 + $1,000) N d + $1,000
2 2
rd = $12.33 ÷ $990,00
rd = 12.26%
($1,000 − $980)
$120 +
rd = 15
($980 + $1,000)
2
Approximate after-tax cost of debt = 12.26% × (1 − 0.4) = 7.36%
e. The interpolated cost of debt is closer to the actual cost (12.2983%) than using the
approximating equation. However, the short cut approximation is fairly accurate and
expedient in the absence of a financial calculator.

P10-3. LG2: Before-tax cost of debt and after-tax cost of debt

Easy
a. Use the model: PV = $ annual coupon interest (PVIFA) + par value (PVIF)
Solving for the discount rate
N = 10, PV = – 930 (an expenditure),
PMT = 0.6(1000) = 60, FV = 1000
b. Use the model: After-tax cost of debt = before-tax cost of debt × (1 – tax bracket)
7.0% (1 – 0.2) = 5.6%

P10-4. LG 2: Cost of debt–using the approximation formula:

Basic

$1,000 − N d
I+
rd = n ri = rd × (1 − T)
N d + $1,000
2
Bond A
$1,000 − $955
$90 +
20 $92.25
rd = = = 9.44%
$955 + $1,000 $977.50
2
ri = 9.44% × (1 − 0.40) = 5.66%
 Chapter 10 The Cost of Capital 5

Bond B
$1,000 − $970
$100 +
16 $101.88
rd = = = 10.34%
$970 + $1,000 $985
2
ri = 10.34% × (1 − 0.40) = 6.20%
Bond C
$1,000 − $955
$120 +
15 $123
rd = = = 12.58%
$955 + $1,000 $977.50
2
ri = 12.58% × (1 − 0.40) = 7.55%
Bond D
$1,000 − $985
$90 +
25 $90.60
rd = = = 9.13%
$985 + $1,000 $992.50
2
ri = 9.13% × (1 − 0.40) = 5.48%
Bond E
$1,000 − $920
$110 +
22 $113.64
rd = = = 11.84%
$920 + $1,000 $960
2
ri = 11.84% × (1 − 0.40) = 7.10%

P10-5. LG 2: After-tax cost of debt

Intermediate
a. Since the interest on the boat loan is not tax deductible, its after-tax cost equals its stated cost
of 8%.
b. Since the interest on the second mortgage is tax deductible, its after-tax cost is found by
multiplying the before-tax cost of debt by (1 – tax rate). Being in the 28% tax bracket, the
after-tax cost of debt is 6.6% (9.2(1 – 0.28)).
c. Home equity loan has a lower after-tax cost. However, using the second home mortgage does
put the Starks at risk of losing their home if they are unable to make the mortgage payments.

P10-6. LG 2: Cost of preferred stock: rp = Dp ÷ N p

Basic
$12.00
a. rp = = 12.63%
$95.00
$10.00
b. rp = = 11.11%
$90.00
6 Gitman • Principles of Managerial Finance, Brief Fifth Edition

P10-7. LG 2: Cost of preferred stock: rp = Dp ÷ Np

Basic

Preferred Stock Calculation

A rp = $11.00 ÷ $92.00 = 11.96%
B rp = 3.20 ÷ 34.50 = 9.28%
C rp = 5.00 ÷ 33.00 = 15.15%
D rp = 3.00 ÷ 24.50 = 12.24%
E rp = 1.80 ÷ 17.50 = 10.29%

P10-8. LG 3: Cost of common stock equity–capital asset pricing model (CAPM)

Intermediate
rs = RF + [b × (rm − RF)]
rs = 6% + 1.2 × (11% − 6%)
rs = 6% + 6%
rs = 12%
a. Risk premium = 6%
b. Rate of return = 12%
c. After-tax cost of common equity using the CAPM = 12%

D1 + g
P10-9. LG 3: Cost of common stock equity: kn =
Nn
Intermediate
D
a. g = 2009 = FVIFk %,4
D2005
$3.10
g= = 1.462
$2.12
From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years).
Calculator solution: 9.97%
b. N n = $52 (given in the problem)
D2010
c. rr = +g
P0
$3.40
rr = + 0.10 = 15.91%
$57.50
D2010
d. rr = +g
Nn
$3.40
rr = + 0.10 = 16.54%
$52.00
 Chapter 10 The Cost of Capital 7

P10-10. LG 3: Retained earnings versus new common stock

Intermediate

D1 D1
rr = +g rn = +g
P0 Nn

Firm Calculation
A rr = ($2.25 ÷ $50.00) + 8% = 12.50%
rn = ($2.25 ÷ $47.00) + 8% = 12.79%
B rr = ($1.00 ÷ $20.00) + 4% = 9.00%
rn = ($1.00 ÷$18.00) + 4% = 9.56%
C rr = ($2.00 ÷ $42.50) + 6% = 10.71%
rn = ($2.00 ÷ $39.50) + 6% = 11.06%
D rr = ($2.10 ÷ $19.00) + 2% = 13.05%
rn = ($2.10 ÷ $16.00) + 2% = 15.13%

P10-11. LG 4: WACC–book weights

Basic
a.

Type of Capital Book Value Weight Cost Weighted Cost

L-T debt $ 700,000 0.500 5.3% 2.650%
Preferred stock 50,000 0.036 12.0% 0.432%
Common stock 650,000 0.464 16.0% 7.424%
$1,400,000 1.000 10.506%

b. The WACC is the rate of return that the firm must receive on long-term projects to maintain
the value of the firm. The cost of capital can be compared to the return for a project to determine
whether the project is acceptable.

P10-12. LG 4: WACC–book weights and market weights

Intermediate
a. Book value weights:

Type of Capital Book Value Weight Cost Weighted Cost

L-T debt $4,000,000 0.784 6.00% 4.704%
Preferred stock 40,000 0.008 13.00% 0.104%
Common stock 1,060,000 0.208 17.00% 3.536%
$5,100,000 8.344%
8 Gitman • Principles of Managerial Finance, Brief Fifth Edition

b. Market value weights:

Type of Capital Market Value Weight Cost Weighted Cost

L-T debt $3,840,000 0.557 6.00% 3.342%
Preferred stock 60,000 0.009 13.00% 0.117%
Common stock 3,000,000 0.435 17.00% 7.395%
$6,900,000 10.854%

c. The difference lies in the two different value bases. The market value approach yields the
better value since the costs of the components of the capital structure are calculated using the
prevailing market prices. Since the common stock is selling at a higher value than its book
value, the cost of capital is much higher when using the market value weights. Notice that the
book value weights give the firm a much greater leverage position than when the market value
weights are used.

P10-13. LG 4: WACC and target weights

Intermediate
a. Historical market weights:

Type of Capital Weight Cost Weighted Cost

L-T debt 0.25 7.20% 1.80%
Preferred stock 0.10 13.50% 1.35%
Common stock 0.65 16.00% 10.40%
13.55%

b. Target market weights:

Type of Capital Weight Cost Weighted Cost

L-T debt 0.30 7.20% 2.160%
Preferred stock 0.15 13.50% 2.025%
Common stock 0.55 16.00% 8.800%
12.985%

c. Using the historical weights the firm has a higher cost of capital due to the weighting of the
more expensive common stock component (0.65) versus the target weight of (0.55). This
over-weighting in common stock leads to a smaller proportion of financing coming from the
significantly less expense L-T debt and the lower costing preferred stock.
 Chapter 10 The Cost of Capital 9

P10-14. LG 2, 3, 4, 5: Calculation of specific costs, WACC, and WMCC

Challenge
a. Cost of debt: (approximate)
($1,000 − N d )
I+
rd = n
( N d + $1,000)
2
($1,000 − $950)
$100 +
10 $100 + $5
rd = = = 10.77%
($950 + $1,000) $975
2
ri = 10.77 × (l − 0.40)
ri = 6.46%
Dp
Cost of preferred stock: rp =
Np

$8
rp = = 12.70%
$63
D1
Cost of common stock equity: rs = +g
P0

D2009
g= = FVIFk %,4
D2005

$3.75
g= = 1.316
$2.85
From FVIF table, the factor closest to 1.316 occurs at 7% (i.e., 1.311 for 4 years).
Calculator solution: 7.10%
$4.00
rr = + 0.07 = 15.00%
$50.00
Cost of new common stock equity:
$4.00
rn = + 0.07 = 16.52%
$42.00
AFj
b. Breaking point =
Wj

[$7,000,000 × (1 − 0.6* )]
BPcommon equity = = $5,600,000
0.50
Between $0 and $5,600,000, the cost of common stock equity is 15% because all common stock
equity comes from retained earnings. Above $5,600,000, the cost of common stock equity is
16.52%. It is higher due to the flotation costs associated with a new issue of common stock.
10 Gitman • Principles of Managerial Finance, Brief Fifth Edition

*
The firm expects to pay 60% of all earnings available to common shareholders as dividends.
c. WACC—$0 to $5,600,000: L-T debt 0.40 × 6.46% = 2.58%
Preferred stock 0.10 × 12.70% = 1.27%
Common stock 0.50 × 15.00% = 7.50%
WACC = 11.35%
d. WACC—above $5,600,000: L-T debt 0.40 × 6.46% = 2.58%
Preferred stock 0.10 × 12.70% = 1.27%
Common stock 0.50 × 16.52% = 8.26%
WACC = 12.11%

P10-15. LG 4: Weighted-average cost of capital

Intermediate

Rate Outstanding Loan Balance Weight WACC

[1] [2] [2] ÷ 64,000 = [3] [1] × [3]
Loan 1 6.00% $20,000 31.25% 1.88%
Loan 2 9.00% $12,000 18.75% 1.69%
Loan 3 5.00% $32,000 50.00% 2.50%
Total $64,000 6.06%

John Dough should not consolidate his college loans because their weighted cost is less than
the 7.2% offered by his bank.

P10-16. LG 2, 3, 4, 5: Calculation of specific costs, WACC, and WMCC

Challenge
a. Debt: (approximate)
($1,000 − N d )
I+
rd = n
( N d + $1,000)
2
($1,000 − $940)
$80 +
20 $80 + $3
rd = = = 8.56%
($940 + $1,000) $970
2
ri = rd × (1 − t)
ri = 8.56% × (1 − 0.40)
ri = 5.14%
Preferred stock:
Dp
rp =
Np
$7.60
rp = = 8.44%
$90
 Chapter 10 The Cost of Capital 11

Common stock:
Dj
rn = +g
Nn
$7.00
rp = = 0.06 = 0.1497 = 14.97%
$78
Retained earnings:
D1
rr = +g
P0
$7.00
rp = + 0.06 = 0.1378 = 13.78%
$90

AFj
b. Breaking point =
Wi

1. BPcommon equity =
[$100,000 ] = $200,000
0.50

Target Cost of
Capital Capital Source Weighted
Type of Capital Structure% Cost
2. WACC equal to or below
$200,000 BP:
Long-term debt 0.30 5.1% 1.53%
Preferred stock 0.20 8.4% 1.68%
Common stock equity 0.50 13.8% 6.90%
WACC = 10.11%
3. WACC above $200,000 BP:
Long-term debt 0.30 5.1% 1.53%
Preferred stock 0.20 8.4% 1.68%
Common stock equity 0.50 15.0% 7.50%
WACC = 10.71%

P10-17. LG 4, 5, 6: Integrative–WACC, WMCC, and IOS

Challenge
a. Breaking points and ranges:

Source of Range of New Breaking Range of Total

Capital Cost% Financing Point New Financing
Long-term debt 6 $0−$320,000 $320,000 ÷ 0.40 = $800,000 $0−$800,000
8 $320,001 Greater than
and above $800,000
Preferred stock 17 $0 and above Greater than $0
Common stock 20 $0−$200,000 $200,000 ÷ 0.40 = $500,000 $0−$500,000
equity 24 $200,001 Greater than
12 Gitman • Principles of Managerial Finance, Brief Fifth Edition

and above $500,000

 Chapter 10 The Cost of Capital 13

b. WACC will change at $500,000 and $800,000.

c. WACC

Source of Target Weighted Cost

Range of Total Capital Proportion Cost% (2) × (3)
New Financing (1) (2) (3) (4)
$0 – $500,000 Debt 0.40 6 2.40%
Preferred 0.20 17 3.40%
Common 0.40 20 8.00%
WACC = 13.80%
$500,000 – $800,000 Debt 0.40 6% 2.40%
Preferred 0.20 17% 3.40%
Common 0.40 24% 9.60%
WACC = 15.40%
Greater than Debt 0.40 8% 3.20%
$800,000 Preferred 0.20 17% 3.40%
Common 0.40 24 9.60%
WACC = 16.20%

d. IOS data for graph

Initial Cumulative
Investment IRR Investment Investment
E 23% $200,000 $ 200,000
C 22 100,000 300,000
G 21 300,000 600,000
A 19 200,000 800,000
H 17 100,000 900,000
I 16 400,000 1,300,000
B 15 300,000 1,600,000
D 14 600,000 2,200,000
F 13 100,000 2,300,000
14 Gitman • Principles of Managerial Finance, Brief Fifth Edition

e. The firm should accept Investments E, C, G, A, and H, since for each of these, the IRR on the
marginal investment exceeds the WMCC. The next project (i.e., I) cannot be accepted since its
return of 16% is below the weighted marginal cost of the available funds of 16.2%.

P10-18. Ethics problem

Intermediate
The company would likely try to deny the claim on the basis that no damages have been sustained
or proven by the claimant. The claimant would argue that the company might not be around to
pay damages when the symptoms emerge and that the damage has already been done even if the
symptoms are not present.

„ Case
Making Star Products’ Financing/Investment Decision
The Chapter 10 case, Star Products, is an exercise in evaluating the cost of capital and available investment
opportunities. The student must calculate the component costs of financing, long-term debt, preferred
stock, and common stock equity; determine the breaking points associated with each source; and calculate
the WACC. Finally, the student must decide which investments to recommend to Star Products.

1. Cost of financing sources

Debt:
Below $450,000:
($1,000 − N d )
I+
rd = n
( N d + $1,000)
2
($1,000 − $960)
$90 +
rd = 15
($960 + $1,000)
2
$92.67
rd = = 0.0946 = 9.46%
$980
 Chapter 10 The Cost of Capital 15

ri = rd × (1 − t)

ri = 9.46 × (1 − 0.4)
ri = 5.68%
Above $450,000: ri = rd × (1 − t)
ri = 13.0 × (1 − 0.4)
ri = 7.8%
Preferred stock:

Dp
rp =
Np
$9.80
rp = = 0.1508 = 15.08%
$65
Common stock equity:
$0−$1,500,000:
Di
rr = +g
P0
$0.96
rr = + 0.11 = 19%
$12
Above $1,500,000:
Di
rr = +g
Nn
$0.96
rr = + 0.11 = 21.67%
$9
2. Breaking points
AFj
Breaking point =
Wi
$450,000
BPLong-term debt = = $1,500,000
0.30
$1,500,000
BPcommon equity = = $2,500,000
0.60
3. Weighted average cost of capital:

Target Capital Cost of Capital Weighted

Type of Capital Structure % Source Cost
1. From $0 to $1,500,000:
Long-term debt 0.30 5.7% 1.71%
Preferred stock 0.10 15.1% 1.51%
Common stock equity 0.60 19.0% 11.40%
16 Gitman • Principles of Managerial Finance, Brief Fifth Edition

1.00 WACC = 14.62%

2. From $1,500,000 to $2,500,000:
Long-term debt 0.30 7.8% 2.34%
Preferred stock 0.10 15.1% 1.51%
Common stock equity 0.60 19.0% 11.40%
1.00 WACC = 15.25%
3. Above $2,500,000:
Long-term debt 0.30 7.8% 2.34%
Preferred stock 0.10 15.1% 1.51%
Common stock equity 0.60 21.7% 13.02%
1.00 WACC = 16.87%
 Chapter 10 The Cost of Capital 17

4.

5. Projects C, D, B, F, and E should be accepted, because each has an IRR greater than the WACC.
These projects will require $2,400,000 in new financing.

„ Spreadsheet Exercise
The answer to Chapter 10’s measurement of the cost of capital at Nova Corporation spreadsheet problem
is located in the Instructor’s Resource Center at www.prenhall.com/irc.

„ A Note on Web Exercises

A series of chapter-relevant assignments requiring Internet access can be found at the book’s Companion
Website at http://www.prenhall.com/gitman. In the course of completing the assignments students access
information about a firm, its industry, and the macro economy, and conduct analyses consistent with those
found in each respective chapter.