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Cost Of Capital and WACC

Chapter 9 p382
P9-1, P9-5, P9-7, P9-10, P9-14
P9-1: Concepts of cost of capital: Mace Manufacturing is in the process of analyzing its investment decision making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions; North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.
Basic variables North South
cost $6 million $5 million
life 15 years 15 years
expected return 8% 15%
least-cost financing 7%
source debt equity
cost (post tax) 7% 15%
decision
action invest don't invest
reason 8%>7% cost 12%<16% cost
A. An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendations do you think this analyst will make regarding the investment?
B. Another analyst assigned to study the South facility believes that funding for the project will come from the firm's retained earnings at a cost of 16%. What recommendation do you expect this analyst to make regarding the investment?
C. Explain why the decision in part A and B may not be in the best interest of the firm's investors? North is 8% >7% and South is 12%<16%
D. If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.
E. If both analysts had used the weighted average cost calculated in part D, what recommendations would they recommendations would they have made regarding the North and South facilities?
F. Compare and contrast the analyst's initial recommendations with your findings in part E. Which decision method seems more appropriate? Explain why?
P9-5 the cost of debt:
Gronseth Drywall Systems, Inc. is in discussions with its investment bankers regarding the issuance of the bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives. In each case, the bonds will have a $1000.00 par value and floatation costs will be $30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with each of the following alternatives:
Alternative Coupon rate Time to maturity (years) Premium or discount
A 9% 16 $250.00
B 7% 5 50
C 6% 7 PAR
D 5% 10 -75
A.
B.
C.
D.

P9-7 Cost of preferred stock:
Taylor Systems has just issued preferred stock. The stock has 12% annual dividend and a $100 par value and was sold at $95.50 per share. In addition, floatation costs of $2.50 per share must be paid.
A. Calculate the cost of the preferred stock.
$12.00
A rp= $95.00 = 12.63%

B. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00 after floatation costs, what is its cost?
B rp= $10.00
$90.00 = 11.11%

P9-10 Cost of common stock equity: kn=D1+g /Nn
Ross textiles wish to measure its cost of common stock equity. The firm's stock is currently for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2016). The dividends for the past 5 years are shown in the following table:
Year Dividend
2015 $3.10
2014 $2.92
2013 $2.60
2012 $2.30
2011 $2.12

After underpricing and flotation costs, the firm expects to net $52 per share on a new issue.
A. Determine the growth rate of dividends from 2011-2015
N=4 (2011-2015) PV (initial value) = -$2.12 FV (terminal value) = $3.10 solve for I (growth rate)
=9.97%
B. Determine the net precedes Nn that the firm will actually receive.
Nn=$
C. Using the constant growth variation model, determine the cost of retained earnings, Rr.
Rr= (next dividend / Current price) + growth rate
(3.40/57.50) +0.0997
0.0591 + 0.0997= 0.1588 =15.88%
D. Using constant growth valuation model, determine the cost of new common stock, Rn.
(3.40 / $52.00) + 0.0997
0.0654 + 0.0997= 0.1651 =16.51%
P9-14 WACC: book weights and market weights
Webster Company has compiled the information shown in the following table.
Source of Capital Book value Market value After-tax cost
Long-term debt $4,000,000 $3,840,000 6.00%
Preferred stock 40,000 60,000 13
Common stock equity 1,060,000 3,000,000 17
totals 5,100,000 6,900,000

A. Calculate the weighted average cost of capital using the book value weights.
WACC = r(E) × w(E) + r(D) × (1 - t) × w(D)
B. Calculate the weighted average cost of capital using the market value weights.
WACC = r(E) × w(E) + r(D) × (1 - t) × w(D)
C. Compare your answers obtained in part A and B. explains the differences.

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Solution Preview

Your answers to 9.7 B and 9.10 are correct.
The process to answer other questions is explained in the attached Excel File.
There appears to be minor discrepancy in the data for Question 9.1. I have corrected Cost of equity to 16% from 15% and made necessary change in the last row reason 15% < 16% cost from 12% <16% cost.

P9-1: Concepts of cost of capital: Mace Manufacturing is in the process of analyzing its investment decision making procedures. Two projects evaluated by the firm recently involved building new facilities in different regions; North and South. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the following table.
Basic variables North South
cost $6 million $5 million
life 15 years 15 years
expected return 8% 15%
least-cost financing source Debt Equity
cost (post tax) 7% 16%
decision
action Invest don't invest
reason 8%>7% cost 15%<16% cost

A.    An analyst evaluating the North facility expects that the project will be financed by debt that costs the firm 7%. What recommendations do you think this analyst will make regarding the investment?

The analyst will accept the project if he/she compares the cost of debt only with the return from the project to arrive at the decision since expected return> after tax cost of debt

B.    Another analyst assigned to study the South facility believes that funding for the project will come from the firm's retained earnings at a cost of 16%. What recommendation do you expect this analyst to make regarding the investment?

The analyst will reject the project if he/she compares the cost of equity only with the return from the project to arrive at the decision since expected return < cost of equity

C.     Explain why the decision in part A and B may not be in the best interest of the firm's investors? North is 8% >7% and South is 15%<16%

The firm is investing in a projct North which provides a return of only 8% while at the same time rejecting a project, South, which gives a higher return of 15%.
This is not in the best interests of the firm's investors.

D.    If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.

Source of Capital Weights After-tax cost weight x After tax Cost Explanation
Debt 40.00% 7% 2.80% =40.% X 7.%
Common stock equity 60.00% 16% 9.60% =60.% X 16.%
totals 100% Total 12.40%

weighted average cost of capital (WACC)= 12.40%

E.     If both analysts had used the weighted average cost calculated in part D, what recommendations would they recommendations would they have made regarding the North and South facilities?

expected return WACC Criteria Decision
North 8% 12.40% expected return < WACC Reject Project
South 15% 12.40% expected return > WACC Accept project

F.     Compare and contrast the analyst's initial recommendations with your findings in part E. Which decision method seems more appropriate? Explain why?

Analyst's initial recommendations are opposite to recommendations in part E
Analysts would choose project North and reject project South.
E chooses project South and rejects project North.

The more appropriate decision is to use the firm's WACC instead of the cost of the least cost financing source.
A firm undertakes different projects and raises different sources of financing for these projects.
Suppose at one time only debt is available and it finances the project with 8% return with debt whose cost ...

Solution Summary

Answers 5 questions on cost of capital, cost of preferred stock, cost of equity.

$2.19