FFM 11ce SM Chapter11

Chapter 11
Discussion Questions
11-1. Though an investment financed by low-cost debt might appear acceptable at first glance,
the use of debt could increase the overall risk of the firm and eventually make all forms
of financing more expensive. Each project must be measured against the overall cost of
funds to the firm.
11-2. The cost of a source of financing directly relates to the required rate of return for that
means of financing. Of course, the required rate of return is used to establish valuation.
11-3. In computing the cost of capital, we use the current costs for the various sources of
financing rather than the historical costs. We must consider what these funds will cost us
to finance projects in the future rather than their past costs.
11-4. Even though debt and preferred stock may be both priced to yield 10 percent in the
market, the cost of debt is less because the interest on debt is a tax-deductible expense. A
10 percent market rate of interest on debt will only cost a firm in a 40 percent tax bracket
an aftertax rate of 6 percent. The answer is the yield multiplied by the difference of (one
minus the tax rate).
11-5. The two sources of equity capital are retained earnings and new common stock.
11-6. Retained earnings belong to the existing common shareholders. If the funds are paid out
instead of reinvested, the shareholders could earn a return on them. Thus we say retaining
funds for reinvestment carries an opportunity cost.
11-7. Because shareholders can earn a return at least equal to their present investment. For this
reason, the firm's rate of return (Ke) serves as a means of approximating the opportunities
for alternate investments.
11-8. In issuing new common stock, we must earn a slightly higher return than the normal cost
of common equity in order to cover the distribution costs of the new security. In the case
of the Baker Corporation, the cost of new common stock was six percent higher.
11-9. The weights are determined by examining different capital structures and using that mix
which gives the minimum cost of capital. We must solve a multidimensional problem to
determine the proper weights.
11-10. The logic of the U-shaped approach to cost of capital can be explained through Figure
11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital
will go down. After we reach an optimum point, the increase use of debt will increase the
overall cost of financing to the firm. Thus we say the weighted average cost of capital
curve is U-shaped.
11-1
Block et al. Foundations of Financial Management 11Ce Solutions Manual
© 2018 McGraw-Hill Education. All Rights Reserved.
Prepared by J. Douglas Short
Chapter 11
11-11. Other possible ratios influencing the cost of capital might be:
• times interest earned
• fixed charge coverage
and indirectly
• net income / sales
• net income / total assets
• net income / shareholders’ equity
11-12. If the firm cannot earn the overall cost of financing on a given project, the investment
will have a negative impact on the firm's operations and will lower the overall wealth of
the shareholders. Clearly, it is undesirable to invest in a project yielding 8 percent if the
financing cost is 10 percent.
11-13. Inflation can only have a negative impact on a firm's cost of capital-forcing it to go up.
This is true because inflation tends to increase interest rates and lower stock prices, thus
raising the cost of debt and equity directly and the cost of preferred stock indirectly.
Note, however, that a proper cost of capital calculation requires marginal and current
market costs. As such the component costs reflect market participants’ inflationary
expectations.
11-14. The marginal cost of capital is the cost of incremental funds. After a firm reaches a given
level of financing, capital costs will go up because the firm must tap more expensive
sources. For example, new common stock may be needed to replace retained earnings as
a source of equity capital.
11-15. The dividend valuation model suggests that investors’ required rates of return are based
on future dividends. Does this fully reflect investors required returns? Furthermore future
dividends that must be projected are difficult to determine, and the growth model
assumes growth at a constant rate forever. The growth rate must also be translated into
dividends flowing through to shareholders. The model must also assume that the share
price is efficiently determined.
11-16. Investors base their expected returns on their market value investment, not on how much
they had invested at some time in the past. The costs of financing in an efficient market
are based on the market value capital structure and not on how the books report that
structure.
Internet Resources and Questions

1. www.sedar.com
2. www.pfin.ca/canadianfixedincome/Default.aspx www.dbrs.com
www.standardandpoors.com
11-2
Chapter 11
3. www.reuters.com/finance/stocks
Discussion Questions: Appendix 11-A

11A-1. The capital asset pricing model explains the relationship between risk and return, and the
price adjustment of capital assets to changes in risk and return. As investors react to their
economic environment and their willingness to take risk, they change the prices of
financial assets like common stock, bonds, and preferred stock. As the prices of these
securities adjust to investors' required returns, the company's cost of capital is adjusted
accordingly.
11A-2. K e = D1 / P0 + g, while K j = R f + β j (R m – R f)
K j and K e are equal when the market is in equilibrium because the expected return K e
will be equal to the required return K j. K e is the return expected by investors based on
dividends and dividend growth, which will cause the stock price to grow accordingly. K j
is the return required to be received, but K j is related to the minimum required return on
a risk free security plus a risk premium relative to the market return. The beta in the K j
equation expresses the individual company’s return relationship to the risk premium
required.
11A-3. The SML, Security Market Line, reflects the risk-return tradeoffs of securities. As
interest rates increase, the SML moves up parallel to the old SML. Now investors require
a higher minimum return on risk free assets and an equally higher rate for all levels of
risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to
provide the appropriate inflation premium and there is an upward shift in the SML.
In regard to changing investor expectations, as investors become more risk averse, the
SML increases its slope. The more risk taken, the greater the return premium that is
desired (see figure 11A-4).
11A-4. If an individual security lies above the SML, this could suggest market inefficiency. The
expected return from investing in that security is higher than one should expect given the
risk assumed. Therefore it is a good investment. As other investors realize the same
abnormally high return they will invest causing the security’s price to rise. This is good
for the investor. As the security’s price rises its return will drop until it reaches the SML.
11A-5. An efficient market assumes that all pertinent information is quickly and continuously
impounded into asset prices. The result is that abnormal profits cannot be achieved
consistently, and investors are properly compensated for the risk they assume from
investment. The CAPM assumes a relationship that properly describes return as a
function of market related risk. All securities lie on a linear line, the SML. If the market
is inefficient because information is not included in prices, it is likely that securities will
not lie along the SML.
11-3
Chapter 11
11A-6. The CAPM is a good theoretical framework for describing a relationship between risk
and return. Nevertheless several aspects of the model may not be appropriate for the
financial manager. The parameters of the model are historical and difficult to determine
in practice. The model is based on diversified holdings whereas a financial manager is
likely not diversified and therefore the manager’s concept of risk is somewhat broader.
The CAPM is based on a one period time frame, but the financial manager should have a
longer focus in decision making. The CAPM assumes an efficient market as well. While
that may be close to true in the capital markets, the financial manager operates in the
markets for technology, machinery, and so on, which are far from efficient. The
relationship between risk and return under these circumstances becomes less than clear.
Additionally beta is not very stable for individual stocks. The ultimate test is if the model
can predict well.
Discussion Questions: Appendix 11-B

11B-1. Under the net income (NI) approach, it is assumed that the firm can raise all the funds it
desires at a constant cost of equity and debt. Since debt tends to have a lower cost than
equity, the more debt utilized the lower the overall cost of capital and the higher the
valuation of the firm.
Under the net operating income (NOI) approach, the cost of capital and valuation do not
change with the increased utilization of debt. Under this proposition, the low cost of debt
is assumed to remain constant with greater debt utilization, but the cost of equity
increases to such an extent that the cost of capital remains unchanged.
The traditional approach falls somewhere between the net income (NI) approach and the
net operating income (NOI) approach in which there are benefits from increased debt
utilization, but only up to a point. After that point, the cost of capital begins to turn up
and the valuation of the firm begins to turn down.
11B-2. Under the initial Modigliani and Miller approach, the use of debt does not change the cost
of capital. This is because the added risk premium associated with the use of debt cancels
out any lower cost benefits. Also, investors could use homemade leverage to arbitrage the
difference between undervalued and overvalued securities.
11B-3. Corporate tax considerations tend to make the tax deductibility of interest on debt highly
attractive and to lower the cost of capital at all levels. However, the potential threat of
bankruptcy has the opposite effect and tends to make the cost of capital more expensive
with greater debt utilization. The net effect is that these influences tend to offset each
other and lead us back to the traditional, U-shaped approach.
11-4
Chapter 11
Problems
11-1. Hertz Pain Relievers
No, each individual project should not be measured against the specific
means of financing that project, but rather against the weighted average
cost of financing all projects for the firm. This principle recognizes that
the availability of one source of financing is dependent on other sources.
Once a common overall cost is determined, the “heating compound”
yielding 14 percent is much more likely to be accepted than the
“massage machine” only yielding 8 percent.
11-2. Royal Petroleum Co.
Weighted
a. Cost Weights Cost
Debt 6% 50% 3.0%

Common equity 18% 50% 9.0%
Weighted average cost of capital 12%
b. Only the new machine with a return of 16 percent. The return

exceeds the weighted average cost of capital of 12.0 percent.
11-3. Pogo Stick Co.

Kd = Yield (1 – T)
= 9% (1 – .25)
= 9% (.75)
= 6.75%
11-5
Chapter 11
11-6
Chapter 11
11-4. Law Suit Settlement
Calculator: PV =? FV = 0 PMT = $240,000

N = 50 %I/Y = 4%
Compute: PV = $5,155,724
Present Value at 4% Appendix D

PVA = A × PVIFA (4%, 50 periods)
PVA = $240,000 × 21.482 = $5,155,680
Calculator: PV =? FV = 0 PMT = $240,000
N = 50 %I/Y = 8%
Compute: PV = $2,936,036
Calculator Difference = $5,155,724 ̶ $2,936,036 = $2,219,688

Present Value at 8% Appendix D
PVA = A × PVIFA (8%, 50 periods)
PVA = $240,000 × 12.233 = $2,935,920
PV at 4% rate $5,155,680
PV at 8% rate 2,935,920
Difference $2,219,760
11-5. Aftertax Debt Cost

Yield (1 – T) Yield (1 – T)
a. 8.0% (1 – .22) 6.24%
b. 14.0% (1 – .36) 8.96%
c. 11.5% (1 – .42) 6.67%
11-7
Chapter 11

Yield (1 – T) Yield (1 – T)
d. 8.0% (1 – .18) 6.56%
e. 12.0% (1 – .34) 7.92%
f. 10.6% (1 – .15) 9.01%

Kd = [Yield / (1 – F)] (1 – T)
= [10%/ (1 – 1%)](1 – .34)
= 6.67%
11-8. Goodsmith Charitable Foundation
a. Kd = Yield (1 – T)
Yield = 9% × 1.25 = 11.25%
Kd = 11.25% (1 – 0) = 11.25% (1) = 11.25%

b. Kd = 11.25% (1 – .30) = 11.25% (.70) = 7.875%
11-9. Waste Disposal Systems

Kd .06 .06
Y= = = = 0.0895 = 8.95%
(1 - T ) 1 − 0.33 0.67
11-8
Chapter 11
11-10. Octopus Transit

a.
Principal payment - Price of the bond
Annual interest payment +
Number of years to maturity
Y1 =
0.6 (Price of the bond ) + 0.4 (Principal payment)
$1,000 − $1,092
$75 +
10 $75 − $9.20
= = = 0.0624 = 6.24%
0.6 ($1,092) + 0.4 ($1,000) $655.20 + $400
Calculator: PV = $1,092 FV = $1,000

PMT = 75/2 = $37.50
N = 10 × 2 = 20 %I/Y =?
Compute: %I/Y = 3.124 × 2 = 6.25%
b. Kd = Yield (1 – T)
= 6.25% (1 – .35)
= 6.25% (.65)
= 4.063%
11-11. Russell Container Company

a.
Principal payment - Price of the bond
Annual interest payment +
Number of years to maturity
Y1 =
0.6 (Price of the bond ) + 0.4 (Principal payment)
$1,000 − $920
$95 +
20 $95 + $4
= = = 0.1040 = 10.40%
0.6 ($920) + 0.4 ($1,000) $552 + $400
Calculator: PV = $920 FV = $1,000 PMT = $95

N = 20 %I/Y =?
Compute: %I/Y = 10.47%
b. K d (approx) = 10.40% (1 – T) K d = Yield (1 – T)
= 10.40% (1 – .25) = 10.47% (1 – .25)
11-9
Chapter 11
= 10.40% (.75) = 10.47% (.75)

= 7.80% = 7.85%
11-10
Chapter 11
11-12. Russell Container Company (Continued)

= 11.47% (1 –.34)
= 11.47% (.66)
= 7.57%
b. It has gone down. Although the before-tax yield is higher, the larger tax
deduction (34 percent versus 25 percent) more than offsets the higher rate.
11-13. Terrier Company
= 10% (1 – .40)
= 10% (.60)
= 6.00%
b. Kd(new) = Yield (1 – T)
= 9% (1 – .25)
= 9% (.75)
= 6.75%
c. It has gone up. The before-tax yield is lower, but the lower
tax rate reduces the tax benefit. The reduced tax benefit
more than offsets the lower rate.
11-14. Suncor
a. 4.26%
b. 4.26% + 0.15% = 4.41%
c. K d = Yield (1 – T)
= 4.41% (1 – .30)
= 4.41% (.70)
11-11
Chapter 11
= 3.087%
11-12
Chapter 11
11-15. Schuss Inc.

Dp $7 $7
a. K p = = = = 0.1228 = 12.28%
Pp − F $60 − $3 $57
b. No tax adjustment is required. Preferred stock dividends are not a

tax deductible expense for the issuing firm.
11-16. Meredith Corporation

Dp $8
Kp = = = 0.1067 = 10.67%
Pp $75
11-17.
Radio Gaga
D p $1.50
(yield only) K p = = = 0.06 = 6.0%
Pp $25
Kp .06
(flotation expense adjutment) K p = = = 0.0632 = 6.32%
1 − F 1 − 0.05
11-18. Sutton Security Systems
Aftertax cost of debt

= 10.5% (1 – .34)
= 10.5% (.66)
= 6.93%
Aftertax cost of preferred stock
11-13
Chapter 11
Dp $4.40 $4.40
Kp = = = = 0.0917 = 9.17%
Pp $50 − $2 $48
Yes, the treasurer is correct. The difference is 2.24% (6.93% versus 9.17%).
11-19. Ellington Electronics
D1 $1.50
a. K e = +g= + 0.08 = 0.05 + 0.08 = 0.1300 = 13.00%
P0 $30
D  P   $30 
b. K n =  1 + g  0  = 0.1300  = 0.1393 = 13.93%
 0
P  n 
P  $30 − $2 
11-14
Chapter 11
11-20. Cost of Equity

D1 $4.60
a. K e = +g= + 0.06 = 0.0767 + 0.06 = 0.1367 = 13.67%
P0 $60
D  P   $60 
K n =  1 + g  0  = 0.1367  = 0.1465 = 14.65%
 0
P  n 
P  $60 − $4 
D1 $0.25
b. K e = +g= + 0.10 = 0.0125 + 0.10 = 0.1125 = 11.25%
P0 $20
D  P   $20 
K n =  1 + g  0  = 0.1125  = 0.1216 = 12.16%
 0
P  n 
P  $20 − $1.50 
c. D1 = 30%  E1 = 30%  $6.00 = $1.80

D1 $1.80
Ke = +g= + 0.045 = 0.072 + 0.045 = 0.1170 = 11.70%
P0 $25
D  P   $25 
K n =  1 + g  0  = 0.1170  = 0.1272 = 12.72%
 0
P  n 
P  $25 − $2.00 
d. D1 = Do (1 + g) = $3.00  (1.07) = $3.21

D1 $3.21
Ke = +g= + 0.07 = 0.0764 + 0.07 = 0.1464 = 14.64%
P0 $42
D  P   $42 
K n =  1 + g  0  = 0.1464  = 0.1577 = 15.77%
 P0  Pn   $42 − $3.00 
11-15
Chapter 11
11-21. Sam’s Fine Garments
PV $1.87
a. FV IF ( Appendix A) = = = 1.87 @ n = 6 : %i = 11%
FV $1.00
Calculator: PV = $1.00 FV = $1.87 PMT = 0
N=6 %I/Y =?
Compute: %I/Y = 10.996%
b. E1 = E o (1 + g)
= $1.87 (1.11)
= $2.08
c. D1 = E1  40%
= $2.08  40%
= $0.83
D1 $0.83
d. K e = +g= + 0.1100 = 0.0553 + 0.1100 = 0.1653 = 16.53%
P0 $15
D  P   $15 
e. K n =  1 + g  0  = 0.1653  = 0.1871 = 18.71%
 0
P  n 
P  $15 − $1.75 
11-16
Chapter 11
11-22. Tyler Oil Company

Cost Weighted
(after tax) Weights Cost
Debt (K d).................................. 7.0% 35% 2.45%
Preferred stock (K p)................. 10.0 15 1.50
Common equity (K e)
(retained earnings)............. 13.0 50 6.50
Weighted average cost of capital (Ka) 100 10.45%
11-23. Tyler Oil Company (Continued)

Cost Weighted
Debt (K d).................................. 8.8% 60% 5.28%
Common equity (K e)
The plan presented in the previous problem is the better

alternative. Even though the second plan has more relatively cheap
debt, the increased costs of all forms of financing more than offset
this factor.
11-17
Chapter 11
11-24. Genex Corporation
= 11% (1 – 0.30)
= 11% (.70)
= 7.7%
The bond yield of 11% is used rather than the coupon rate of 13%
because bonds are priced in the market according to competitive
yields to maturity. The new bond is sold to reflect yield to
maturity.
Dp $10.00 $10.00
Kp = = = = 0.1081 = 10.81%
Pp − F $98 − $5.50 $92.50
D1 $3
Ke = +g= + 0.08 = 0.06 + 0.08 = 0.1400 = 14.00%
P0 $50
Cost Weighted
Debt (K d).................................. 7.70% 35% 2.70%
Common equity (K e)
11-18
Chapter 11
11-25. Hadley Corporation
= 7% (1 – .34)
= 7% (.66)
= 4.62%
Dp $9.00 $9.00
Kp = = = = 0.0911 = 9.11%
Pp − F $102 − $3.20 $98.80
D1 $3.50
Ke = +g= + 0.06 = 0.05 + 0.06 = 0.1100 = 11.00%
P0 $70
Cost Weighted
Debt (K d).................................. 4.62% 30% 1.39%
Common equity (K e)
11-19
Chapter 11
11-26. Puppet Corporation

a. Internally Generated funds
Y (1 − T ) .07(1 − .35) .0455
Kd = = = = 0.0464 = 4.64%
1− F 1 − 0.02 0.98
D p / Pp .05 .05
Kp = = = = 0.0515 = 5.15%
1− F 1 − .03 0.97
D1 $1.50
Ke = +g= + 0.06 = 0.05 + 0.06 = 0.1100 = 11.00%
P0 $30
Cost Weighted
Debt (K d).................................. 4.64% 55% 2.55%
Common equity (K e)
b. Externally generated funds
D1
+g
P0 0.11 0.11
Kn = = = = 0.1146 = 11.46%
1− F 1 − 0.04 0.96
Cost Weighted
Debt (K d).................................. 4.64% 55% 2.55%
Common equity (K e)
(new share issue)................ 11.46 40 4.58
c. A new share issue incurs flotation costs (use of investment dealer, lawyers,
etc.). Internally generated funds only come from shareholders claim on
earnings (and amortization). All new funding for debt, preferred and new
11-20
Chapter 11
common shares requires access to capital markets and thus flotation costs are
incurred.
11-21
Chapter 11
11-27. Valvano Publishing Company
= 13% (1 – .34)
= 13% (.66)
= 8.58%
Dp $5.50 $5.50
Kp = = = = 0.1134 = 11.34%
Pp − F $50 − $1.50 $48.50
Dp $5.50
Pp 0.1100
or : = $50 = = 0.1134 = 11.34%
(1 − F ) (1 − 0.03) 0.97
$50 × 0.03= $1.50
D1 $2.52
Ke = +g= + 0.11 = 0.056 + 0.11 = 0.1660 = 16.60%
P0 $45
Cost Weighted
Debt (K d).................................. 8.58% 35% 3.00%
Common equity (K e)
11-22
Chapter 11
11-28. McNabb Construction Company
= 10.5%/ (1 – 30) = 10.5% (.70) = 7.355%
Kp = Dp/(Pp – F)
= ($8.50/$90.00) / (1 – .02)= .0944/0.98 = .0964 = 9.64%
Ke = (D1/P0)+ g
D1 = $3.15
P0 = $98.44
g= 12% (see below)
$.24/2.00 = 12.0%
.27/2.24 = 12.1%
.30/2.51 = 12.0%
g = Calculator: PV =$2.00 FV = $3.15 PMT = 0

N=4 %I/Y or g =?
Compute: %I/Y = 12.03%
Ke = (D1/P0)+ g
$3.15/$98.44 + 12.03% = 3.2% + 12.03% = 15.23%
Cost Weighted
Debt (Kd) ......................... 7.355% 30% 2.21%
Preferred stock (Kp) ........ 9.64 12% 0.96
Common equity (Ke)
(retained earnings) ........ 15.23 60% 9.14
Weighted average cost
of capital (Ka) ...........................................................100100
12.31%
11-23
Chapter 11
11-24
Chapter 11
11-29. Western Electric Utility Company
a. Realize that the cost of debt is related to the cost of debt for
other debt issues of the same risk class. Although, in actuality,
the rate Western Electric might pay will not be exactly equal to
TransCanada, it should be close enough to serve as an
approximation. Both are utilities that are rated A.
= 4.20% (1 – .30)
= 4.20% (.70)
= 2.94%
Dp $9.00 $9.00
b. K p = = = = 0.0914 = 9.14%
Pp − F $100 − $1.50 $98.50
D1 $4.50
c. K e = +g = + 0.06 = 0.075 + 0.06 = 0.1350 = 13.50%
P0 $60
d. Cost Weighted
Debt (K d).................................. 2.94% 40% 1.18%
Common equity (K e)
11-25
Chapter 11
11-30. Eaton International Corporation
Retained Earnings
a. X=
% of retained earnings in the capital structure
= $19.5 million/.65 = $30 million
Amount of lower cost debt

b. Z =
% of debt in the capital structure
= $14 million/.25 = $56 million
11-31. Nolan Corporation

a. Cost (after tax) Weights WACC
Debt (K d).................................. 5.60% 45% 2.52%
Common equity (K e)
Retained earnings
b. X =
% of retained earnings in capital structure
$12 million
X = = $30 million
.40
c. Cost (after tax) Weights WACC

Debt (K d).................................. 5.60% 45% 2.52%
Common equity (K n)................ 13.20 40 5.28
11-26
Chapter 11
Marginal cost of capital (K mc) 100 9.15%

d. Z =
% of debt within the capital structure
$18 million
Z= = $40 million
.45
e. Cost (after tax) Weights WACC

Debt (K d).................................. 7.20% 45% 3.24%
Common equity (K n)................ 13.20 40 5.28
11-27
Chapter 11
11-32. Evans Corporation

a. Cost (after tax) Weights WACC
Debt (K d).................................. 6.20% 30% 1.86%
Common equity (K e)
Retained earnings
b. X =
$20 million
X= = $33.33 million
.60
c. Cost (after tax) Weights WACC

Debt (K d).................................. 6.20% 30% 1.86%
Common equity (K n)................ 13.40 60 8.04

d. Z =
$36 million
Z= = $120 million
.30
e. Cost (after tax) Weights WACC

Debt (K d).................................. 7.80% 30% 2.34%
Common equity (K n)................ 13.40 60 8.04
11-28
Chapter 11
11-29
Chapter 11
11-33. Eaton Electronic Company
a. Kj = Rf. + β(Rm – Rf)

= 7% + 1.6 (10% – 7%)
= 7% + 1.6 (3%)
= 7% + 4.80% = 11.80%
D1 $0.70
b. Ke = +g= + 0.08 = 0.0368 + 0.08 = 0.1168 = 11.68%
P0 $19
Although the values almost equal in this example, that is not

always the case.
11-30
Chapter 11
Comprehensive Problems
11-34. Medical Research Corporation
Marginal Cost of Capital and Investment Returns
a. K d = Yield (1 – T)
= 11% (1 – .30)
= 11% (.70)
= 7.70%
D1 $0.90
Ke = +g = + 0.11 = 0.036 + 0.11 = 0.1460 = 14.60%
P0 $25
Cost (aftertax) Weights WACC
Debt (K d).................................. 7.70% 40% 3.08%
Common equity (K e)
Weighted average cost of capital (Ka) 11.84%
Retained earnings
b. X =
$15 million
X = = $25 million
.60
D  P   $25 
c. K n =  1 + g  0  = 0.1460  = 0.1659 = 16.59%
 0
P  n 
P  $25 − $3 

Debt (K d).................................. 7.70% 40% 3.08%
Common equity (K n)................ 16.59 60 9.95
Marginal cost of capital (K mc) 13.03%
11-31
Chapter 11
11-32
Chapter 11

d. Z =
$20 million
Z= = $50 million
.40
e. First compute the new value for K d

Kd = Yield (1 - T)
= 13% (1 – .30)
= 13% (.70)
= 9.10%
Debt (K d).................................. 9.10% 40% 3.64%
Common equity (K n)................ 16.59 60 9.95
Marginal cost of capital (K mc) 13.59%
f. The answer is $ 50 million.

Return on Marginal
Investment Cost of Capital
1st $25 million 18.0% > 11.84%
$25 million – $50 million 14.0% > 13.03%
$50 million – $75 million 11.8% < 13.59%
$75 million – $100 million 10.9% < 13.59%
11-33
Chapter 11
Medical Research Corporation
20.00%
18.00%
16.00%
14.00%
Kmc
Kmc 13.59%
12.00% 13.03
11.84% Kmc %
10.00% Rate of return
8.00%
6.00%
4.00%
2.00%
0.00%
25 50 75 100
Amount of capital required (millions)
Top of bar represents return on investment

Dotted line represents marginal cost of capital (K mc)
Invest up to $50 million
11-34
Chapter 11
11-35. Masco Oil and Gas Company

Cost of Capital with Changing Financial Needs
a. The before tax cost of debt will be equal to the market rate of
12.1%. The student must realize that the historical cost of the three
bonds does not influence the cost of debt.
= 12.1% (1 – .4)
= 12.1% (.60)
= 7.26%
b. The fact that the preferred stock carries a coupon rate of 7.5%
does not influence K p, which is dependent upon current prices and
the dividend.
Dp $7.80 $7.80
Kp = = = = 0.1006 = 10.06%
Pp − F $80 − $2.50 $77.50
D1 $1.90
c. K e = +g = + 0.08 = 0.0475 + 0.08 = 0.1275 = 12.75%
P0 $40
D  P   $40 
d. K n =  1 + g  0  = 0.1275  = 0.1349 = 13.49%
 0
P  n 
P  $40 − $2.20 
e. Only those sources of capital that are expected to be used as long-run
optimum components of the capital structure should be included in the
weighted average cost of capital. The firm states that all their funds can be
supplied by retained earnings (50%); therefore, we do not need to include
new common stock or preferred stock in our calculation of the weighted
cost of capital.
Debt (K d).................................. 7.26% 50% 3.63%
Common equity (K e)................ 12.75 50 6.37
Weighted average of capital (Ka) 10.00%
11-35
Chapter 11
11-36
Chapter 11
11-36. A Dozen Monkeys Ltd.

Debt: Market Value PVA = A × PVIFA (n = 12, i = 10%) (Appendix D)
= 8% × $8,000,000 × 6.814 = $4,360,960
PV = FV × PVIF (n = 12, i = 10%) (Appendix B)
= $8,000,000 × 0.319 = $2,552,000
Total = $4,360,960 + $2,552,000 = $6,912,960
Calculator: PV =? FV = $8,000,000 PMT = $640,000

N = 12 %i = 10%
Compute: PV = $6,909,809
Cost Kd = [Y/ (1 – F)] (1 – T)
= [10%/ (1 – .03)](1 – .40) = 6.19%
Dp $1,000,000  0.05
Preferreds: Market Value: Pp = = = $625,000
Kp 0.08
Yield .08 .08

Cost: K p = = = = 0.0833 = 8.33%
(1 − F ) (1 − 0.04) 0.96
Equity: Market Value: = $15 × 750,000 shares outstanding
= $11,250,000
Cost (new shares required)
D  P   $1.50  $15.00 
K n =  1 + g  0  =  + .06  
 0
P  n 
P  $ 15  $14.25 − $ 14. 25(.05 ) 
$15
= .1600  = 0.1773 = 17.73%
$13.54
Overall: Market Value Weighting Cost Overall
Debt $ 6,909,809 .3678 .0619 .0228
Preferreds 625,000 .0333 .0833 .0028
Equity 11,250,000 .5989 .1773 .1062
$18,784,809 1.0000 .1318
11-37
Chapter 11
A Dozen Monkeys’ Cost of Capital = 13.18%
11-38
Chapter 11
11-37. Island Capital

Bonds: Market Value PVA = A × PVIFA (n = 18, i = 11%) (Appendix D)
= 8% × $20,000,000 × 7.702 = $12,323,200
PV = FV × PVIF (n = 18, i = 11%) Appendix B
= $20,000,000 × 0.153 = $3,060,000
Total = $12,323,200 + $3,060,000
= $15,383,200
Calculator: PV =? FV = $20,000,000 PMT = $1,600,000
N = 18 %i = 11%
Compute: PV = $15,379,030
Cost Kd = [Y/ (1 – F)] (1 – T)
= [11% / (1 – .025)] (1 – .39)
= 6.88%
Dp $4,000,000  0.09
Perpetuals: Market Value: Pp = = = $4,500,000
Kp 0.08
Dp $50  0.08 $4.00

Kp = = = = 0.0825 = 8.25%
Pp − F $50 − $50  0.03 $48.50
Cost: Dp $4.00
Pp 0.0800
or : = $50 = = 0.0825 = 8.25%
(1 − F ) (1 − 0.03) 0.97
Equity: Market Value: = $18 × 4,000,000 shares outstanding
= $72,000,000
Cost: (internally generated funds sufficient)
D1 $1.75
Ke = +g = + 0.07 = 0.0972 + 0.07 = 0.1672 = 16.72%
P0 $18
11-39
Chapter 11
a. Overall: Market Value Weighting Cost Overall

Debt $15,379,030 .1674 .0688 .0115
Preferreds 4,500,000 .0490 .0825 .0040
Equity 72,000,000 .7836 .1672 .1310
$91,879,030 1.0000 .1465
Island Capital’s Cost of Capital = 14.65%
b. Cost: if new shares required are required flotation costs and a

price under-pricing will occur for new shares, raising the cost to
the firm.
D  P   $18 
K n =  1 + g  0  = 0.1672  = 0.1810 = 18.10%
 0
P  n 
P  $17.50 − $17.50  0.05 

Debt $15,379,030 .1674 .0688 .0115
Preferreds 4,500,000 .0490 .0825 .0040
Equity 72,000,000 .7836 .1810 .1418
$91,879,030 1.0000 .1573
Island Capital’s Cost of Capital = 15.73%
11-40
Chapter 11
11-38. Trois-Rivieres Manufacturing
Note: Semiannual payments; $10,000,000 × 0.10 × ½

Debt: Market Value PVA = A × PVIFA (n = 16, i = 6%) (Appendix D)
= 5% × $10,000,000 × 10.106 = $5,053,000
PV = FV × PVIF (n = 16, i = 6%) (Appendix B)
= $10,000,000 × 0.394 = $3,940,000
Total = $5,053,000 + $3,940,000
= $8,993,000

N = 8 × 2 = 16 %i = 12%/ 2 = 6%
Compute: PV = $8,989,410
Cost Kd = [Y/ (1 – F)] (1 – T)
= [12.36% / (1 – .04)] (1 – .38)
= 7.98%
Preferreds: Market Value Pp = $26.50 × 100,000 shares o/s

= $2,650,000
Cost: Dividend =$2,500,000 × .075 ÷ 100,000 shares = $1.875
Dp $2,500,000  0.075 $187,500

Kp = = = = 7.45%
Pp − F $2,650,000 − $2,650,000  0.05 $2,517,500
Dp $1.875
Pp 0.0708
or : = $26.50 = = 0.0745 = 7.45%
(1 − F ) (1 − 0.05) 0.95
11-41
Chapter 11
Equity: Market Value = $15 × 600,000 shares o/s

= $9,000,000
Cost: (new shares required)
g = Calculator: PV = ̶ $0.80 FV = $1.23 PMT = 0

N=5 %i or g =?
Compute: %i = 8.98%
D  P   $1.23  1.0898  $15.00 

K n =  1 + g  0  =  + .0898 
 0
P  n 
P  $ 15  $ 15. 00 − $15. 00(. 07 ) 
$15
= (0.0894 + 0.0898)  = 0.1927 = 19.27%
$13.95

Debt $ 8,989,410 .4355 .0798 .0348
Preferreds 2,650,000 .1284 .0745 .0096
Equity 9,000,000 .4361 .1927 .0840
$20,639,410 1.0000 .1284
Trois Rivieres’ Cost of Capital = 12.84%
11-42
Chapter 11
11-39. Murchie’s
a.
Debt: Market Value = $10,000,000 × 1.15
= $11,500,000
Effective Yield:
Calculator: PV = 115 FV = 100 PMT = 12/ 2 = 6
N = 15 × 2 = 30 %I/Y = ?
Compute: %I/Y = 5.0218% (semiannual)
Annual yield = (1 + .050218)2 – 1
= 0.1030 or 10.30%
Cost: Kd = [Y/ (1 – F)] (1 – T)
= [10.30%/ (1 – .03)] (1 – .43)
= 6.05%
Perpetual bonds:
Dp $2,000,000  0.09
Market Value: Pp = = = $1,500,000
Kp 0.12
Cost (if tax deductible):

Yield
Kp = (1 − T ) = .12 (1 − 0.43) = 0.1250(0.57) = 7.13%
(1 − F ) (1 − 0.04)
Equity: Market Value = $4.50 × 750,000 shares o/s
= $3,375,000
Cost (new shares required)
D  P   $0.10  $4.50 
K n =  1 + g  0  =  + .15  
 0
P  n 
P  $4.50  $4.10 
= (0.0222 + 0.15)  1.0976 = 0.1890 = 18.90%
11-43
Chapter 11

Debt $11,500,000 .7023 .0605 .0425
Preferreds 1,500,000 .0916 .0713 .0065
Equity 3,375,000 .2061 .1890 .0390
$16,375,000 1.0000 .0880
Murchie’s Cost of Capital = 8.80%
b. Overall: Market Value Weighting Cost Overall

Debt $11,500,000 .7023 .1062 .0746
Preferreds 1,500,000 .0916 .1250 .0115
Equity 3,375,000 .2061 .1890 .0390
$16,375,000 1.0000 .1251
Murchie’s Cost of Capital (without tax savings on debt) = 12.51%
Kd = 10.30%/ (1 – .03)
= 10.62%
(Perpetuals) K d = 12%/ (1 – .04)
= 12.50%
c. Murchie’s is highly leveraged. It is taking a chance with lots of debt,

particularly in a risky business. Murchie’s however seems to be getting
away with it as the suppliers of capital, primarily through debt, have not yet
demanded higher yields. Tax savings from debt are being well utilized
providing there is sufficient cash flow to service the debt and income to take
advantage of the tax savings. However, the share price appears depressed. A
firm with volatile earnings and cash flow should stay away from highly
leveraged positions (unless the bankers haven’t caught on).
d. The weighted average cost of capital can be used assuming new acquisitions
will be financed in the same proportions as in the calculation, and the new
acquisitions are of the same risk as the average of Murchie’s present assets.
The possibility of the new acquisitions being of the same risk seems highly
unlikely given that diversification is the objective. Diversification by its
nature requires a portfolio of different risk assets. Furthermore the cost of
11-44
Chapter 11
capital may be affected by the risk reduction of Murchie’s through

diversification.
11-45
Chapter 11
Problems: Appendix 11-A
11A-1.
a. Kj = Rf + βj (Rm – Rf)
= 4% + 0.7(8 % – 4%)
= 4% + 0.7(4%)
= 4% + 2.8%
= 6.8%
b. Kj = 4% + 1.4(8% – 4%)
= 4% + 1.4(4%)
= 4% + 5.6%
= 9.6%
c. Kj = 4% + 1.7(8% – 4%)
= 4% + 1.7(4%)
= 4% + 6.8%
= 10.8%
11A-2.
a. Kj = 7% + 0.7(6.5%)
= 7% + 4.55%
= 11.55%
b. Kj = 7% + 1.4(6.5%)
= 7% + 9.1%
= 16.1%
c. Kj = 7% + 1.7(6.5%)
= 7% + 11.05%
= 18.05%
11-46
Chapter 11
11A-3. Kj = Rf + βj (Rm – Rf)

= 7% + 1.2(13% – 7%)
= 7% + 1.2(6%)
= 7% + 7.2%
= 14.2%
P1 = $15 + 14.2% × $15 (no dividends)
= $17.13
11A-4. Kj = Rf + βj (Rm – Rf)

= 4.75% + 1.15(6.90%)
= 4.75% + 7.935%
= 12.685%
With no capital appreciation g = 0.
One period time frame
P0 = D1/ Kj
= $1.80/ 12.685%
= $14.19
11A-5. Kj = Rf + βj (Rm – Rf)

Rm = 16%
Rm – Rf = 7%
Therefore Rf = Rm – 7%
= 16% – 7%
= 9%
Kj = 9% + 1.05(7%)
= 9% + 7.35%
= 16.35%
11-47
Chapter 11
11A-6. Y Ltd.
a. Kj = Rf + βj (Rm – Rf)
= 5% + 1.2(8%)
= 5% + 9.6%
= 14.6%
b. An expected return of 16% suggests that you are more than adequately
compensated for the risk you are assuming (CAPM suggests 14.6% is
adequate). Buy Y Ltd. If the return is more than adequate the price of shares
should rise until the return is appropriate given the risk assumed.
11A-7. Austen Sensibles Ltd,

Debt: Cost Kd = Y (1 – T)
= 11.00% (1 – .44)
= 6.16%
Preferreds: Cost K p = Dp/ (Pp – F)
= 8% / (1 – .05)
= 8.42%
Equity: Cost Kj = Rf + βj (Rm – Rf)
= 8.5% + 0.9 (16% – 8.5%)
= 8.5% + 0.9 (7.5%)
= 8.5% + 6.75%
= 15.25%
Debt n.a .3500 .0616 .0216
Preferreds n.a .1000 .0842 .0084
Equity n.a .5500 .1525 .0839
n.a 1.0000 .1139
Austen Sensible’s Cost of Capital = 11.39%
11-48
Chapter 11
11A-8. Huron Ltd.

Debt: Market Value PVA = A × PVIFA (n = 14, %i = 9.5) (Appendix
D)
= 16% × $30,000,000 × 7.572
= $36,345,600
PV = FV × PVIF (n = 14, i = 9.5%) (Appendix
B)
= $30,000,000 × 0.281
= $8,430,000
Total = $36,345,600 + $8,430,000
= $44,775,600
Calculator: PV =? FV = $30,000,000 PMT = $4,800,000

N = 14 %i = 9.5%
Compute: PV = $44,765,111
Cost: Kd = [Y / (1 – F)] (1 – T)
= [9.5% / (1 – .04)] (1 – .40)
= 5.94%
Dp $3,000,000  0.08
Preferreds: Market Value: Pp = = = $3,692,308
Kp 0.065
Yield .065
Cost: K p = = = 0.0684 = 6.84%
(1 − F ) (1 − 0.05)
Equity: Market Value = $15.50 × 3,600,000 shares o/s
= $55,800,000
Cost: (internal funds)
11-49
Chapter 11
K j = R f + β j (Rm - R f )
= 0.05 + 1.25 (0.08)
= 0.05 + 0.10
= 0.15 = 15%

Debt $ 44,765,111 .4294 .0594 .0255
Preferreds 3,692,308 .0354 .0684 .0024
Equity 55,800,000 .5352 .1500 .0803
$104,257,419 1.0000 .1082
Huron’s Cost of Capital = 10.82%
b. Prime plus 1 percent is 8% and would be an adequate return if all financing

came from the bank and is short term. However the bank’s lending rate is
probably based on the conservatively financed capital structure of Huron. If
the equity position was to be changed from over 50 percent in the future the
bank would likely require a slightly higher rate on its loans. Furthermore the
equity holders demand a return of 15 percent and projects that only return 8
percent will eventually disappoint the shareholders, despite the use of debt
that lowers the cost of capital to 10.82 percent. The investor will be
disappointed if projects returning less than 10.82 percent are accepted given
the present capital structure.
11-50
Chapter 11
11A-9. Orbit Corp.

Demand loans: Market Value: We assume that the market value is the same
as the book value because these loans have interest rates that
float with current market yields and are payable anytime.
Cost: = (Prime + 1%) (1 – T)
= (9.5% + 1%) (1 – .23)
= 10.5% (.77)
= 8.09%
Debt: Market Value: PVA = A × PVIFA (N = 12, %I/Y = 12) (App. D)

= 8% × $12,000,000 × 6.194 = $5,946,240
PV = FV × PVIF (N = 12, %I/Y = 12) (App. B)
= $12,000,000 × 0.257 = $3,084,000
Total = $5,946,240 + $3,084,000
= $9,030,240
N = 12 %I/Y = 12%
Compute: PV = $9,026,700
Cost Kd = [Y/ (1 – F)] (1 – T)
= [12% / (1 – .05)] (1 – .23)
= 12.63% (.77)
= 9.73%
Dp $7,000,000  0.06
Preferreds: Market Value: Pp = = = $3,818,182
Kp 0.11
Yield .11
Cost: K p = = = 0.1170 = 11.70%
(1 − F ) (1 − 0.06)
Equity: Market Value: = $25 × 5,000,000 shares o/s
= $125,000,000
11-51
Chapter 11
Cost (new shares required):

P   
K j = R f + β j (Rm - R f ) 0  = 0.085 + 1.7 (0.09)
$25
 Pn   $25 − $25  0.08 
 $25 
= 0.085 + 0.153 = 0.238  1.08696 = 0.2587 = 25.87%
 $23 
R f + β j (Rm - R f ) 0.238 0.238
or := = = = .2587 = 25.87%
(1 − F ) (1 − 0.08) 0.92

Loans $ 3,000,000 .0213 .0809 .0017
Debt 9,026,700 .0641 .0973 .0062
Preferreds 3,818,182 .0271 .1170 .0032
Equity 125,000,000 .8875 .2587 .2296
$140,844,882 1.0000 .2407
Orbit’s Cost of Capital = 24.07%
b. No. A growth company with good prospects (lots of projects with NPV > 0)
should maintain generated cash flow in the corporation. Based on projects
which exceed investor expectations the corporation is likely to do better with
the cash flow than the shareholder who would have to invest dividends
elsewhere. A growth company will attract shareholders (clientele) expecting
capital appreciation not dividends. Dividends might change their perceptions
of the company.
c. Use more debt. Almost 90 percent of Orbit Corp. is financed with equity.
This forces the cost of capital higher requiring investments to surpass the
high cost of capital to be acceptable. Debt is cheaper and also has the
advantage of tax savings because the interest can be expensed for tax
11-52
Chapter 11
purposes. Initial levels of lower priced debt will not greatly increase the
corporation’s risk or the costs of the components of the capital structure.
Therefore through averaging, the cost of capital will be lowered which will
prove beneficial to shareholders.
11-53

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Chapter 11

Internet Resources and Questions

Discussion Questions: Appendix 11-A

Discussion Questions: Appendix 11-B

11-1. Hertz Pain Relievers

11-2. Royal Petroleum Co.

Debt 6% 50% 3.0%

b. Only the new machine with a return of 16 percent. The return

11-3. Pogo Stick Co.

11-4. Law Suit Settlement

Calculator: PV =? FV = 0 PMT = $240,000

Present Value at 4% Appendix D

Calculator Difference = $5,155,724 ̶ $2,936,036 = $2,219,688

11-5. Aftertax Debt Cost

11-6. Aftertax Debt Cost

11-7. Aftertax Debt Cost

11-8. Goodsmith Charitable Foundation

Kd = 11.25% (1 – 0) = 11.25% (1) = 11.25%

11-9. Waste Disposal Systems

11-10. Octopus Transit

Calculator: PV = $1,092 FV = $1,000

11-11. Russell Container Company

Calculator: PV = $920 FV = $1,000 PMT = $95

= 10.40% (.75) = 10.47% (.75)

11-12. Russell Container Company (Continued)

11-13. Terrier Company

11-15. Schuss Inc.

b. No tax adjustment is required. Preferred stock dividends are not a

11-16. Meredith Corporation

11-18. Sutton Security Systems

Aftertax cost of debt

11-19. Ellington Electronics

11-20. Cost of Equity

c. D1 = 30%  E1 = 30%  $6.00 = $1.80

d. D1 = Do (1 + g) = $3.00  (1.07) = $3.21

11-21. Sam’s Fine Garments

11-22. Tyler Oil Company

11-23. Tyler Oil Company (Continued)

The plan presented in the previous problem is the better

11-24. Genex Corporation

11-25. Hadley Corporation

11-26. Puppet Corporation

11-27. Valvano Publishing Company

11-28. McNabb Construction Company

g = Calculator: PV =$2.00 FV = $3.15 PMT = 0

11-29. Western Electric Utility Company

11-30. Eaton International Corporation

= $19.5 million/.65 = $30 million

Amount of lower cost debt

= $14 million/.25 = $56 million

11-31. Nolan Corporation

c. Cost (after tax) Weights WACC

Marginal cost of capital (K mc) 100 9.15%

Amount of lower cost debt

e. Cost (after tax) Weights WACC

11-32. Evans Corporation

c. Cost (after tax) Weights WACC

Amount of lower cost debt

e. Cost (after tax) Weights WACC