Chapter 11

Determining the Cost of Capital

ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS

The answers to a number of the question are illustrated in the Excel model.

11-1 (1) Debt, (2) preferred stock, and common equity from (3) sale of common stock and
(4) retained earnings. Keep the fact that common equity can be divided into retained
earnings and new common stock in mind, and also note that there are many different
types of debt, with differing costs, as we discuss in later chapters.
From an investor’s standpoint, debt is the least risky holding and thus provides the
lowest return. Therefore, it has the lowest cost, followed by preferred, and then common
stock. Because of flotation costs, equity from retained earnings has a lower cost than
equity from issuing new common stock.
Also, note that interest is deductible to the issuing company, so the already-low cost
of debt is reduced further by multiplying the interest rate by (1-T). The end result is
that the after-tax cost of debt is lowest, preferred is next, and common equity is highest.
Note also, however that corporations can exclude 70% of preferred dividends received
from their taxable income, so corporate investors can accept a lower pre-tax yield on
preferred stock dividends than the yield on bonds and still obtain a higher after-tax return
on the preferred. Thus, the pre-tax cost of preferred is often lowest, followed by debt,
and then common stock. Still, for cost of capital estimating purposes, it is the after-tax
cost that is relevant.

11-2 The WACC is simply a weighted average of the firm’s component costs of capital. This
is the discount rate one should use for free cash flows.

Answers and Solutions: 11 - 1

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website, in whole or in part.
11-3 The weights used should be bases on the firm’s target capital structure. To illustrate,
suppose a company has 50-50 debt and equity at book value, but its stock sells for 1.5
times book and it uses the market value ratio as the target. Here is the situation:

Book Value Data Market Value Data

Debt $50 50% Debt $50 40%

Equity 50 50 Equity $75 60
$100 100% $125 100%

Using book value weights (50-50) would put too much weight on debt, and since debt has
the lower cost, this would bias the WACC downward. The market value weights would
be 40% debt and 60% equity, and this would increase the WACC. If the firm plans to
finance using the target weights, then the WACC based on the 40:60 ratio is correct.
Note also that even if the firm plans to use only debt during a given year, in the capital
budgeting process we should still use the target weight based WACC, for otherwise the
hurdle rate would be too low one year and too high the next.
An interesting issue arises if the firm’s actual capital structure is far removed from the
target, say an actual capital structure with 100% equity and a target of 50-50 debt/equity.
Then, the firm might be able to finance with only debt for a number of years while the
structure is adjusting. Should the WACC used for capital budgeting during this
adjustment period be based only on low-cost debt? One could argue YES, but we would
still favor the use of the target weights on the grounds that the firm could issue a large
amount of debt, use the proceeds to repurchase stock, and bring the actual structure to the
target quickly if it choose to do so.

11-4 a. Using data as given in the model, here is the basic CAPM equation for rs, the cost of
common equity:

rs = rRF + bi(rM – rRF).

= 6% + 1.2(11% - 6%) = 12%.

The spreadsheet model provides some more information on the CAPM method. rRF is
found as the long-term (10 or more years) T-bond yield, and this does not present
much of a problem.

Answers and Solutions: 11 - 2

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 The beta is more problematic. As we saw in Chapter 2, historical betas may or
may not be good measures of future risk, which is what investors are interested in.
Note too that betas from published sources such as Value Line, Merrill Lynch, and
[Link] often differ substantially from one provider to another. So, it is necessary
to consider the beta carefully and make a judgment as to whether it accurately reflects
investors’ perceptions of the company’s risk. Financial staff members of larger
companies often calculate their own betas and then look at the standard errors and R2
values to get an idea of how “good” the beta is. They might also make adjustments to
obtain what they regard as a “better” beta. Still, one must always be concerned about
the accuracy of the beta, and thus the CAPM estimate of rs.
The other data problem is the value of rM. This is supposed to be the expected
rate of return on an average stock as seen by the marginal investor. However, we
cannot identify the marginal investor to determine what his or her expected actually
is. So, the rM must be recognized to be an estimate that might be substantially
inaccurate.
The rM can be estimated in two ways. (1) We can use historical data on stock
returns as provided by Ibbotson Associates or some other source. Ibbotson
recommends this procedure and sells the data. However, this requires the assumption
that investors expect to earn the same returns in the future that they earned in the past,
which may or may not be a good assumption. (2) Alternatively, we can obtain
expected returns on the market as provided by analysts at firms such as Value Line
and Merrill Lynch. However, this requires the assumption that these analysts’
expectations are unbiased and accurately reflect the expectations of the marginal
investor. Analysts have not been particularly good predictors of the future, they
differ among themselves, and there is suspicion that they provide “happy forecasts” in
order to pump up stocks and get their firms’ customers in a buying mode. So again,
there is uncertainty about the validity of a CAPM cost of equity estimate.
Finally, the CAPM equation itself may not really reflect how investors view risks,
and the model has never been proven empirically to be correct. It is logical and
reasonable, but investors may recognize the data problems described above and
therefore not follow the dictates of the CAPM.
In spite of these potential problems, the CAPM is the method of choice in the
academic community, and it is also most widely used by corporations, perhaps
because professors with a CAPM bias trained most corporate analysts. People—
professors, analysts, and students—like specific numbers that they can look up and
then cite the source of the data. People find it easier to justify hard, published
numbers as opposed to judgmental estimates. This may be another reason for the
popularity of historical (Ibbotson) CAPM data.
Finally, note that the CAPM cannot be used for privately-owned firms or for
divisions of public companies unless comparable stand-alone proxies can be found,
and that is difficult.

Answers and Solutions: 11 - 3

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 b. Here is the basic DCF equation for a constant growth stock:

rs = D0 / P0 + g.

= $1(1+g) / $40 + g.

If growth were expected to remain constant, and we had a good estimate of the rate
the marginal investor was using, then we could easily complete the formula and
obtain an estimate of rs. For example, if the constant growth rate was 10%, then in
our example rs would be $1.10/$40 + 10% = 12.75%.
For a non-constant growth stock, solve for rs in the following equation, where gt is
the growth rate in each year t and the g’s vary over time:

D 0 (1 + g t ) t
∞
P0 = ∑
t =1 (1 + rs ) t

See the spreadsheet in ch10BOC-model.

The DCF equation could be used to estimate the “intrinsic value” of a stock, given
an investor’s forecast for future growth and his or her required rate of return on the
stock, rs. Or, given the market price, P0, and the growth rates, we can solve for rs, the
required rate of return, or cost of equity, for the stock. Solving for rs is difficult
unless a spreadsheet is used, but with a spreadsheet is fairly simple. See the model
and printout.
The stock price, P0, is obviously known, as is the last dividend, D0. However, the
estimate of future growth, gt, is not known. As the model printout shows, historical
growth rates vary substantially from year to year, and they also vary depending on
how they are calculated. Moreover, historical growth rates are generally not good
predictors of future growth, so there is no good reason to think that investors should
or do rely heavily on historical rates when they estimate their intrinsic stock values.
Empirical research indicates that while security analysts’ forecast of future growth
are not very good, they are still better than forecasts based just on historical data.
Moreover, studies indicate that investors rely more on security analysts’ growth
forecasts than on historical growth rates when they buy and sell stocks. Therefore,
security analysts’ forecasts are better for use in DCF cost of capital estimates than are
historical growth rates.
Growth is much more predictable for large, stable companies like Anheuser-
Busch than it is for cyclical companies like U.S. Steel, and growth is virtually
unpredictable for most new, small, high-tech start-up companies. So, the DCF
method produces more reliable results for a company like A-B than it does for most
other companies, but even for a company like A-B, the “true” cost of equity could lie

Answers and Solutions: 11 - 4

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website, in whole or in part.
 within a range of perhaps 3 percentage points because growth rate estimates vary that
widely.
c. The own-bond-yield-plus-risk premium method is often criticized as being
“unscientific,” but it is still used, and with good reason. The criticism is that the risk
premium is “judgmental,” but in truth so are many elements of the CAPM and DCF
methods. Moreover, the risk premium is not a complete guess. Careful surveys of
portfolio managers have been taken to provide evidence about the size of the
premium, and, if one likes the historical approach, the Ibbotson data provide
information on historical differentials between stock and corporate bond yields.
Furthermore, researchers have calculated the differential between expected (DCF)
returns on specific stocks versus the bonds of those same companies, and also
between the CAPM cost of equity estimates and bond yields for various companies.
We present a small study of risk premiums on a tab in the BOC model, partly to
give an idea of “over-own-bond-yield” premiums but also to show how these
premiums can be estimated.

11-5 Flotation costs per dollar raised increase as we go from debt to preferred and to common
stock (because it is more difficult for investment bankers to market riskier securities).
Also, flotation costs per dollar of capital raised decline as the firm raises larger and larger
amounts (because some costs are fixed regardless of the issue’s size).
Flotation costs increase the cost of capital. However, these costs are generally
ignored for debt because they are small for debt, which is generally privately placed. But
flotation costs are typically taken into account for common and preferred stock because
for these securities flotation costs are often substantial. The result of flotation costs is a
higher WACC, especially when new common stock must be issued.

11-6 The WACC changes over time if the firm makes internal changes, especially (1) changes
its capital structure or (2) invests in assets that are riskier (or less risky) than its past
investments. External factors can also affect the WACC, especially (1) changing interest
rates and stock market conditions and (2) changes in the firm’s competitive environment.
To some extent the firm can influence perceptions, and it is often stated that a highly
regarded manager like Warren Buffett of Berkshire Hathaway can lower a firm’s cost of
capital because they inspire investor confidence.

11-7 The WACC used to evaluate each project should depend on the riskiness of the project—
higher WACC’s should be used for riskier projects. The risk adjustment is largely
subjective, although some companies do apply CAPM techniques to find different costs
of capital for each of their larger divisions. Different capital structures across divisions
can also affect divisional costs of capital. Also, risk analysis techniques such as those
that we will discuss in the capital budgeting chapters can be used to get an idea of
different projects’ risks, and then a somewhat subjective factor can be added to the
WACC for relatively risky projects or deducted for less risky projects.

Answers and Solutions: 11 - 5

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 ANSWERS TO END-OF-CHAPTER QUESTIONS

11-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax
component costs of capital—-debt, preferred stock, and common equity. Each
weighting factor is the proportion of that type of capital in the optimal, or target,
capital structure. The after-tax cost of debt, rd(1 - T), is the relevant cost to the firm
of new debt financing. Since interest is deductible from taxable income, the after-tax
cost of debt to the firm is less than the before-tax cost. Thus, rd(1 - T) is the
appropriate component cost of debt (in the weighted average cost of capital). If a
company has short-term debt with a cost of rstd, then its after-tax cost is rstd(1 - T) is
the appropriate component cost of debt (in the weighted average cost of capital).

b. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock.
For perpetual preferred, it is the preferred dividend, Dps, divided by the net issuing
price, Pn. Note that no tax adjustments are made when calculating the component
cost of preferred stock because, unlike interest payments on debt, dividend payments
on preferred stock are not tax deductible. The cost of new common equity, re, is the
cost to the firm of equity obtained by selling new common stock. It is, essentially,
the cost of retained earnings adjusted for flotation costs. Flotation costs are the costs
that the firm incurs when it issues new securities. The amount actually available to
the firm for capital investment from the sale of new securities is the sales price of the
securities less flotation costs. Note that flotation costs consist of (1) direct expenses
such as printing costs and brokerage commissions, (2) any price reduction due to
increasing the supply of stock, and (3) any drop in price due to informational
asymmetries.

c. The target capital structure is the relative amount of debt, preferred stock, and
common equity that the firm desires. The WACC should be based on these target
weights.

d. There are considerable costs when a company issues a new security, including fees to
an investment banker and legal fees. These costs are called flotation costs. The cost
of new common equity is higher than that of common equity raised internally by
reinvesting earnings. Projects financed with external equity must earn a higher rate of
return, since the project must cover the flotation costs.

11-2 The WACC is an average cost because it is a weighted average of the firm's component
costs of capital. However, each component cost is a marginal cost; that is, the cost of
new capital. Thus, the WACC is the weighted average marginal cost of capital.

Answers and Solutions: 11 - 6

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11-3 Probable Effect on
rd(1 - T) rs WACC

a. The corporate tax rate is lowered. + 0 +

b. The Federal Reserve tightens credit. + + +

c. The firm uses more debt; that is, it

increases its debt/assets ratio. + + 0

d. The firm doubles the amount of capital

it raises during the year. 0 or + 0 or + 0 or +

e. The firm expands into a risky

new area. + + +

f. Investors become more risk averse. + + +

11-4 Stand-alone risk views a project’s risk in isolation, hence without regard to portfolio
effects; within-firm risk, also called corporate risk, views project risk within the context
of the firm’s portfolio of assets; and market risk (beta) recognizes that the firm’s
stockholders hold diversified portfolios of stocks. In theory, market risk should be most
relevant because of its direct effect on stock prices.

11-5 If a company’s composite WACC estimate were 10%, its managers might use 10% to
evaluate average-risk projects, 12% for high-risk projects, and 8% for low-risk projects.
Unfortunately, given the data, there is no completely satisfactory way to specify exactly
how much higher or lower we should go in setting risk-adjusted costs of capital.

Answers and Solutions: 11 - 7

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website, in whole or in part.
 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

11-1 a. rd(1 - T) = 13%(1 - 0) = 13.00%.

b. rd(1 - T) = 13%(0.80) = 10.40%.

c. rd(1 - T) = 13%(0.65) = 8.45%.

11-2 rd(1 - T) = 0.08(0.65) = 5.2%.

11-3 Vps = $50; Dps = $4.50; F = 0%; rps = ?

D ps
rps =
Vps (1 − F)
$4.50
=
$50(1 − 0.0)
= 9%.

$60(0.06) $3.60
11-4 rps = = = 5.41%.
$70.00(1 − 0.05) $66.50

11-5 P0 = $36; D1 = $3.00; g = 5%; rs = ?

D1
rs = + g = ($3.00/$36.00) + 0.05 = 13.33%.
P0

11-6 rs = rRF + bi(RPM) = 0.06 + 0.8(0.055) = 10.4%.

11-7 30% Debt; 5% Preferred Stock; 65% Equity; rd = 6%; T = 40%; rps = 5.8%; rs = 12%.

WACC = (wd)(rd)(1 - T) + (wps)(rps) + (ws)(rs)

WACC = 0.30(0.06)(1-0.40) + 0.05(0.058) + 0.65(0.12) = 9.17%.

Answers and Solutions: 11 - 8

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11-8 40% Debt; 60% Equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?

WACC = (wd)(rd)(1 - T) + (ws)(rs)

9.96% = (0.4)(9%)(1 - 0.4) + (0.6)rs
9.96% = 2.16% + 0.6rs
7.8% = 0.6rs
rs = 13%.

11-9 Enter these values: N = 60, PV = -515.16, PMT = 30, and FV = 1000, to get I = 6% =
periodic rate. The nominal rate is 6%(2) = 12%, and the after-tax component cost of debt
is 12%(0.6) = 7.2%.

D1 $2.14
11-10 a. rs = +g= + 7% = 9.3% + 7% = 16.3%.
P0 $23

b. rs = rRF + (rM - rRF)b

= 9% + (13% - 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

d. The bond-yield-plus-judgmental-risk-premium approach and the CAPM method both

resulted in lower cost of equity values than the DCF method. The firm's cost of
equity should be estimated to be about 15.9%, which is the average of the three
methods.

11-11 a. $6.50 = $4.42(1+g)5

(1+g)5 = $6.50/$4.42 = 1.471
(1+g) = 1.471(1/5) = 1.080
g = 8%.

Alternatively, with a financial calculator, input N = 5, PV = -4.42, PMT = 0,

FV = 6.50, and then solve for I/YR = 8.02% ≈ 8%.

b. D1 = D0(1 + g) = $2.60(1.08) = $2.81.

c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.

Answers and Solutions: 11 - 9

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 D1
11-12 a. rs = +g
P0
$3.60
0.09 = +g
$60.00
0.09 = 0.06 + g
g = 3%.

b. Current EPS $5.400

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

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

11-13 P0 = $30; D1 = $3.00; g = 5%; F = 10%; rs = ?

rs = [D1/(1 - F) P0] + g = [$3/(1 - 0.10)($30)] + 0.05 = 16.1%.

11-14 Enter these values: N = 20, PV =1,000(1 - 0.02) = 980, PMT = -90(1 - 0.4) = -54, and
FV = -1000, to get I/YR = 5.57%, which is the after-tax component cost of debt.

11-15 a. Common equity needed:

0.5($30,000,000) = $15,000,000.

b. Cost using rs:

After-Tax
Percent × Cost = Product
Debt 0.50 4.8%* 2.4%
Common equity 0.50 12.0 6.0
WACC = 8.4%

*8%(1 - T) = 8%(0.6) = 4.8%.

c. rs and the WACC will increase due to the flotation costs of new equity.

Answers and Solutions: 11 - 10

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website, in whole or in part.
11-16 The book and market value of the notes payable are $10,000,000.

The bonds have a value of

V = $60([1/0.10]-[1/(0.1*(1+0.10)20)]) + $1,000((1+0.10)-20)
= $60(8.5136) + $1,000(0.1486)
= $510.82 + $148.60 = $659.42.

Alternatively, using a financial calculator, input N = 20, I/YR = 10, PMT = 60, and FV =
1000 to arrive at a PV = $659.46.
The total market value of the long-term debt is 30,000($659.46) = $19,783,800.
There are 1 million shares of stock outstanding, and the stock sells for $60 per share.
Therefore, the market value of the equity is $60,000,000.
The market value capital structure is thus:

Short-term debt $10,000,000 11.14%

Long-term debt 19,783,800 22.03
Common equity 60,000,000 66.83
$89,783,800 100.00%

11-17 Several steps are involved in the solution of this problem. Our solution follows:

Step 1.

Establish a set of market value capital structure weights. In this case, A/P and accruals
should be disregarded because they are not sources of financing from investors. Instead
of being incorporated into the WACC, they are accounted for when calculating cash
flows. For this firm, short-term debt is used to finance seasonal goods, and the balance is
reduced to zero in off-seasons. Therefore, this is not a source of permanent financing. and
should be disregarded when calculating the WACC.

Answers and Solutions: 11 - 11

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website, in whole or in part.
 Debt:

The long-term debt has a market value found as follows:

40
$40 $1,000
V0 = ∑ t
+ = $699,
t =1 (1.06) (1.06) 40

or 0.699($30,000,000) = $20,970,000 in total. Notice that short-term debt is not included

in the capital structure for this company. We usually include short-term debt in the total
debt figure for calculating weights because in the absence of any other information, we
assume the short-term debt will be rolled over from year to year. In this case, however,
the company does not use short-term debt as a permanent source of financing. Indeed, as
stated in the problem, the short-term debt balance is zero off-season. In such a situation
neither the lender nor the company believes that the debt balance will be rolled over from
year to year as the loan is closed out each off-season and so it is not considered a
component of the capital structure.

Preferred Stock:

The preferred has a value of

$2
Pps = = $72.73.
0.11 / 4

There are $5,000,000/$100 = 50,000 shares of preferred outstanding, so the total market
value of the preferred is

50,000($72.73) = $3,636,500.

Answers and Solutions: 11 - 12

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 Common Stock:

The market value of the common stock is

4,000,000($20) = $80,000,000.

Therefore, here is the firm's market value capital structure, which we assume to be
optimal:

Long-term debt $ 20,970,000 20.05%

Preferred stock 3,636,500 3.48
Common equity 80,000,000 76.47
$104,606,500 100.00%

We would round these weights to 20% debt, 4% preferred, and 76% common equity.

Step 2.

Establish cost rates for the various capital structure components.

Debt cost:

rd(1 - T) = 12%(0.6) = 7.2%.

Preferred stock cost:

Annual dividend on new preferred = 11%($100) = $11. Therefore,

rps = $11/$100(1 - 0.05) = $11/$95 = 11.6%.

Common equity cost:

There are three basic ways of estimating rs: CAPM, DCF, and judgmental risk premium
over own bonds. None of the methods is very exact.

Answers and Solutions: 11 - 13

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website, in whole or in part.
 CAPM:

We would use rRF = T-bond rate = 10%. For RPM, we would use 4.5% to 5.5%. For beta,
we would use a beta in the 1.3 to 1.7 range. Combining these values, we obtain this
range of values for rs:

Highest: rs = 10% + (5.5)(1.7) = 19.35%.

Lowest: rs = 10% + (4.5)(1.3) = 15.85%.
Midpoint: rs = 10% + (5.0)(1.5) = 17.50%.

DCF:
The company seems to be in a rapid, non-constant growth situation, but we do not have
the inputs necessary to develop a non-constant rs. Therefore, we will use the constant
growth model but temper our growth rate; that is, think of it as a long-term average g that
may well be higher in the immediate future than in the more distant future.

We could use as a growth estimator this method:

g = b(ROE) = 0.5(24%) = 12%.

It would not be appropriate to base g on the 30% ROE, because investors do not expect
that rate.
Finally, we could use the analysts' forecasted g range, 10% to 15%. The dividend
yield is D1/P0. Assuming g = 12%,

D1 $1(1.12)
= = 5.6%.
P0 $20

One could look at a range of yields, based on P in the range of $17 to $23, but
because we believe in efficient markets, we would use P0 = $20. Thus, the DCF model
suggests a rs in the range of 15.6% to 20.6%:

Highest: rs = 5.6% + 15% = 20.6%.

Lowest: rs = 5.6% + 10% = 15.6%.
Midpoint: rs = 5.6% + 12.5% = 18.1%.

Generalized risk premium:

Highest: rs = 12% + 6% = 18%.

Lowest: rs = 12% + 4% = 16%.
Midpoint: rs = 12% + 5% = 17%.

Answers and Solutions: 11 - 14

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website, in whole or in part.
 Based on the three midpoint estimates, we have rs in this range:

CAPM 17.5%
DCF 18.1%
Risk Premium 17.0%

Step 3.

Calculate the WACC:

WACC = (D/V)(rdAT) + (P/V)(rps) + (S/V)(rs or re)

= 0.20(rdAT) + 0.04(rps) + 0.76(rs or re).

It would be appropriate to calculate a range of WACCs based on the ranges of component

costs, but to save time, we shall assume rdAT = 7.2%, rps = 11.6%, and rs = 17.5%. With
these cost rates, here is the WACC calculation:

WACC = 0.2(7.2%) + 0.04(11.6%) + 0.76(17.5%) = 15.2%.

Answers and Solutions: 11 - 15

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website, in whole or in part.
 SPREADSHEET PROBLEM

11-18 The detailed solution for the problem is available in the file Ch11 P18 Build a Model
[Link] at the textbook’s web site.

Answers and Solutions: 11 - 16

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website, in whole or in part.
 MINI CASE

During the last few years, Harry Davis Industries has been too constrained by the high cost
of capital to make many capital investments. Recently, though, capital costs have been
declining, and the company has decided to look seriously at a major expansion program
that has been proposed by the marketing department. Assume that you are an assistant to
Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis’s cost
of capital. Jones has provided you with the following data, which she believes may be
relevant to your task:

1. The firm's tax rate is 40%.

2. The current price of Harry Davis’s 12% coupon, semiannual payment, noncallable
bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use
short-term interest-bearing debt on a permanent basis. New bonds would be privately
placed with no flotation cost.

3. The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual
preferred stock is $116.95. Harry Davis would incur flotation costs equal to 5% of the
proceeds on a new issue.

4. Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0)
was $3.12, and dividends are expected to grow at a constant rate of 5.8% in the
foreseeable future. Harry Davis’s beta is 1.2; the yield on T-bonds is 5.6%; and the
market risk premium is estimated to be 6%. For the over-own-bond-yield-plus-
judgmental-risk-premium approach, the firm uses a 3.2% judgmental risk premium.

5. Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and
60% common equity.

To help you structure the task, Leigh Jones has asked you to answer the following
questions.

Mini Case: 11 - 17
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website, in whole or in part.
a. 1. What sources of capital should be included when you estimate Harry Davis’s
weighted average cost of capital (WACC)?

Answer: The WACC is used primarily for making long-term capital investment decisions, i.e.,
for capital budgeting. Thus, the WACC should include the types of capital used to
pay for long-term assets, and this is typically long-term debt, preferred stock (if used),
and common stock. Short-term sources of capital consist of (1) spontaneous,
noninterest-bearing liabilities such as accounts payable and accruals and (2) short-
term interest-bearing debt, such as notes payable. If the firm uses short-term interest-
bearing debt to acquire fixed assets rather than just to finance working capital needs,
then the WACC should include a short-term debt component. Noninterest-bearing
debt is generally not included in the cost of capital estimate because these funds are
netted out when determining investment needs, that is, net rather than gross working
capital is included in capital expenditures.

a. 2. Should the component costs be figured on a before-tax or an after-tax basis?

Answer: Stockholders are concerned primarily with those corporate cash flows that are
available for their use, namely, those cash flows available to pay dividends or for
reinvestment. Since dividends are paid from and reinvestment is made with after-tax
dollars, all cash flow and rate of return calculations should be done on an after-tax
basis.

a. 3. Should the costs be historical (embedded) costs or new (marginal) costs?

Answer: In financial management, the cost of capital is used primarily to make decisions
which involve raising new capital. Thus, the relevant component costs are today's
marginal costs rather than historical costs.

Mini Case: 11 - 18
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website, in whole or in part.
b. What is the market interest rate on Harry Davis’s debt, and what is the
component cost of this debt for WACC purposes?

Answer: Harry Davis’s 12% bond with 15 years to maturity is currently selling for $1,153.72.
Thus, its yield to maturity is 10%:

0 1 2 3 29 30
| | | | • • • | |
-1,153.72 60 60 60 60 60
1,000

Enter N = 30, PV = -1153.72, PMT = 60, and FV = 1000, and then press the I/YR
button to find rd/2 = 5.0%. Since this is a semiannual rate, multiply by 2 to find the
annual rate, rd = 10%, the pre-tax cost of debt.
Since interest is tax deductible, Uncle Sam, in effect, pays part of the cost, and
Harry Davis’s relevant component cost of debt is the after-tax cost:

rd(1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%.

Optional Question

Should flotation costs be included in the estimate?

Answer: The actual component cost of new debt will be somewhat higher than 6% because the
firm will incur flotation costs in selling the new issue. However, flotation costs are
typically small on public debt issues, and, more important, most debt is placed
directly with banks, insurance companies, and the like, and in this case flotation costs
are almost nonexistent.

Mini Case: 11 - 19
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website, in whole or in part.
 Optional Question

Should you use the nominal cost of debt or the effective annual cost?

Answer: Our 10% pre-tax estimate is the nominal cost of debt. Since the firm's debt has
semiannual coupons, its effective annual rate is 10.25%:

(1.05)2 – 1.0 = 1.1025 – 1.0 = 0.1025 = 10.25%.

However, nominal rates are generally used. The reason is that the cost of capital is
used in capital budgeting, and capital budgeting cash flows are generally assumed to
occur at year-end. Therefore, using nominal rates makes the treatment of the capital
budgeting discount rate and cash flows consistent.

c. 1. What is the firm's cost of preferred stock?

Answer: Since the preferred issue is perpetual, its cost is estimated as follows:

D ps 0.1($100) $10
rps = = = = 0.090 = 9.0%.
Pps (1 − F) $116.95(1 − .0.05) $111.10

Note (1) that flotation costs for preferred are significant, so they are included here, (2)
that since preferred dividends are not deductible to the issuer, there is no need for a
tax adjustment, and (3) that we could have estimated the effective annual cost of the
preferred, but as in the case of debt, the nominal cost is generally used.

c. 2. Harry Davis’s preferred stock is riskier to investors than its debt, yet the
preferred's yield to investors is lower than the yield to maturity on the debt.
Does this suggest that you have made a mistake? (Hint: Think about taxes.)

Answer: Corporate investors own most preferred stock, because 70% of preferred dividends
received by corporations are nontaxable. Therefore, preferred often has a lower
before-tax yield than the before-tax yield on debt issued by the same company. Note,
though, that the after-tax yield to a corporate investor, and the after-tax cost to the
issuer, are higher on preferred stock than on debt.

d. 1. What are the two primary ways companies raise common equity?

Answer: A firm can raise common equity in two ways: (1) by retaining earnings and (2) by
issuing new common stock.

Mini Case: 11 - 20
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d. 2. Why is there a cost associated with reinvested earnings?

Answer: Management may either pay out earnings in the form of dividends or else retain
earnings for reinvestment in the business. If part of the earnings is retained, an
opportunity cost is incurred: Stockholders could have received those earnings as
dividends and then invested that money in stocks, bonds, real estate, and so on.

d. 3. Harry Davis doesn’t plan to issue new shares of common stock. Using the
CAPM approach, what is Harry Davis’s estimated cost of equity?

Answer: rs = 0.056 + (0.06)1.2 = 12.8%.

e. 1. What is the estimated cost of equity using the discounted cash flow (DCF)
approach?

∧ D1 D (1 + g) $3.12(1.058)
Answer: rs = = 0 +g = + 0.058 = 12.4%.
P0 P0 $50

e. 2. Suppose the firm has historically earned 15% on equity (ROE) and retained
62% of earnings, and investors expect this situation to continue in the future.
How could you use this information to estimate the future dividend growth rate,
and what growth rate would you get? Is this consistent with the 5.8% growth
rate given earlier?

Answer: Another method for estimating the growth rate is to use the retention growth model:

g = (1 – Payout Ratio)ROE

In this case g = (1 − 0.62)0.15 = 5.7%. This is consistent with the 5.8% rate given
earlier.

e. 3. Could the DCF method be applied if the growth rate was not constant? How?

Answer: Yes, you could use the DCF using nonconstant growth. You would find the PV of the
dividends during the nonconstant growth period and add this value to the PV of the
series of inflows when growth is assumed to become constant.

Mini Case: 11 - 21
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website, in whole or in part.
f. What is the cost of equity based on the bond-yield-plus-judgmental-risk-
premium method?

Answer: rs = Company’s own bond yield + judgmental risk premium.

The YTM of the company’s bonds is 10%.:

The assumed judgmental risk premium is 3.2%, thus

rs = 0.10 + 0.032 = 13.2%.

g. What is your final estimate for the cost of equity, rs?

Answer: The final estimate for the cost of equity would simply be the average of the values
found using the above three methods.

CAPM 12.8%
DCF 12.4
BOND YIELD + RP 13.2
AVERAGE 12.8%

h. What is Harry Davis’s weighted average cost of capital (WACC)?

Answer: WACC= wdrd(1 – T) + wpsrps + ws(rs)

= 0.3(0.10)(1 – 0.4) + 0.1(0.09) + 0.6(0.128)
= 0.1038 = 10.38%.

i. What factors influence a company’s WACC?

Answer: There are factors that the firm cannot control and those that they can control that
influence WACC.
Factors The Firm Cannot Control:
Stock and Bond Markets
The Market Risk Premium Market Environment
Tax Rates

Factors The Firm Can Control:

Capital Structure Policy
Dividend Policy
Investment Policy

Mini Case: 11 - 22
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j. Should the company use the overall, or composite, WACC as the hurdle rate for
each of its divisions?

Answer: No. The composite WACC reflects the risk of an average project undertaken by the
firm. Therefore, the WACC only represents the “hurdle rate” for a typical project
with average risk. Different projects have different risks. The project’s WACC
should be adjusted to reflect the project’s risk.

k. What procedures can be used to estimate the risk-adjusted cost of capital for a
particular division? What approaches are used to measure a division’s beta?

Answer: The following procedures can be used to determine a division’s risk-adjusted cost of
capital:

(1) Subjective adjustments to the firm’s composite WACC.

(2) Attempt to estimate what the cost of capital would be if the division were a
stand-alone firm. This requires estimating the division’s beta.

The following approaches can be used to measure a division’s beta:

(1) Pure play approach. Find several publicly traded companies exclusively in the
project’s business. Then, use the average of their betas as a proxy for the
project’s beta. (It’s hard to find such companies.)

(2) Accounting beta approach. Run a regression between the project’s ROA and
the S&P index ROA. Accounting betas are correlated (0.5 - 0.6) with market
betas. However, you normally can’t get data on new project ROAs before the
capital budgeting decision has been made.

Mini Case: 11 - 23
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website, in whole or in part.
l. Harry Davis is interested in establishing a new division that will focus primarily
on developing new Internet-based projects. In trying to determine the cost of
capital for this new division, you discover that specialized firms involved in
similar projects have on average the following characteristics:
• Their capital structure is 10% debt and 90% common equity.
• Their cost of debt is typically 12%.
• The beta is 1.7.
Given this information, what would your estimate be for the division’s cost of
capital?

Answer:
rs DIV. = rRF + (rM – rRF)bDIV.
= 5.6% + (6%)1.7 = 15.8%.

WACCDIV. = wdrd(1 – T) + wsrs

= 0.1(12%)(0.6) + 0.9(15.8%)
= 14.94%.

The division’s WACC = 14.94% vs. the corporate WACC = 10.38%. The division’s
market risk is greater than the firm’s average projects. Typical projects within this
division would be accepted if their returns are above 14.94%.

m. What are three types of project risk? How can each type of risk be considered
when thinking about the new division’s cost of capital?

Answer: The three types of project risk are:

Stand-Alone Risk
Corporate Risk
Market Risk

Market risk is theoretically best in most situations. However, creditors,

customers, suppliers, and employees are more affected by corporate risk. Therefore,
corporate risk is also relevant. Stand-alone risk is the easiest type of risk to measure.
Taking on a project with a high degree of either stand-alone or corporate risk will
not necessarily affect the firm’s market risk. However, if the project has highly
uncertain returns, and if those returns are highly correlated with returns on the firm’s
other assets and with most other assets in the economy, the project will have a high
degree of all types of risk.

Mini Case: 11 - 24
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website, in whole or in part.
n. Explain in words why new common stock that is raised externally has a higher
percentage cost than equity that is raised internally as retained earnings.

Answer: The company is raising money in order to make an investment. The money has a
cost, and this cost is based primarily on the investors’ required rate of return,
considering risk and alternative investment opportunities. So, the new investment
must provide a return at least equal to the investors’ opportunity cost.
If the company raises capital by selling stock, the company doesn’t receive all of
the money that investors contribute. For example, if investors put up $100,000, and if
they expect a 15% return on that $100,000, then $15,000 of profits must be generated.
But if flotation costs are 20% ($20,000), then the company will receive only $80,000
of the $100,000 investors contribute. That $80,000 must then produce a $15,000
profit, or a $15/$80 = 18.75% rate of return versus a 15% return on equity raised as
retained earnings.

o. 1. Harry Davis estimates that if it issues new common stock, the flotation cost will
be 15%. Harry Davis incorporates the flotation costs into the DCF approach.
What is the estimated cost of newly issued common stock, taking into account
the flotation cost?

Answer:
D0 (1 + g) + g
re =
P0 (1 - F)
$3.12(1.058)
= + 5.8%
$50(1 - 0.15)
$3.30
= + 5.8% = 13.6%.
$42.50

o. 2. Suppose Harry Davis issues 30-year debt with a par value of $1,000 and a
coupon rate of 10%, paid annually. If flotation costs are 2%, what is the after-
tax cost of debt for the new bond?

Answer: Using a financial calculator, N = 30, PV = (1 – 0.02)(1,000) = 980, PMT = -(1 – 0.40)(100) = -60,
FV = -1000. The resulting I/YR is 6.15%, which is the after-tax cost of debt.

Mini Case: 11 - 25
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website, in whole or in part.
p. What four common mistakes in estimating the WACC should Harry Davis
avoid?

Answer: 1. Don’t use the coupon rate on a firm’s existing debt as the pre-tax cost of debt.
Use the current cost of debt.

2. When estimating the risk premium for the CAPM approach, don’t subtract the
current long-term T-bond rate from the historical average return on stocks.
For example, the historical average return on stocks has been about 12.7%. If
inflation has driven the current risk-free rate up to 10%, it would be wrong to
conclude that the current market risk premium is 12.7% – 10% = 2.7%. In all
likelihood, inflation would also have driven up the expected return on the market.
Therefore, the historical return on the market would not be a good estimate of the
current expected return on the market.

3. Don’t use book weights to estimate the weights for the capital structure. Use the
target capital structure to determine the weights for the WACC. If you don’t have
the target weights, then use market value rather than book value to obtain the
weights. Use the book value of debt only as a last resort.

4. Always remember that capital components are sources of funding that come from
investors. If it’s not a source of funding from an investor, then it’s not a capital
component.

Mini Case: 11 - 26
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