Concepts Review and Critical Thinking Questions

1. On the most basic level, if a firm’s WACC is 12 percent, what does this mean?

The minimal rate of return that the company has to achieve overall on its current assets is this.
Value is produced if it makes more than this.

2. In calculating the WACC, if you had to use book values for either debt or equity, which would
you choose? Why?

Compared to equity book values, book values for debt are probably far more in line with
market values.

3. If you can borrow all the money you need for a project at 6 percent, doesn’t it follow that 6
percent is your cost of capital for the project?

No, the project's risk determines the cost of capital rather than the money's source.

4. Why do we use an aftertax figure for the cost of debt but not for the cost of equity?

The cost of interest is tax deductible. The equity expenses before taxes and after taxes are the
same.

5. What are the advantages of using the DCF model for determining the cost of equity capital?
What are the disadvantages? What specific piece of information do you need to find the cost
of equity using this model? What are some of the ways in which you could get this estimate?

The Dividend Discount Model's primary advantage is its simplicity. It does, however, have a
number of drawbacks, including the following: it only applies to dividend-paying companies,
which leaves out a large number of them; it assumes a constant, uniform growth rate in
dividends, which may not be realistic; the calculated equity cost is highly sensitive to changes in
the growth rate, which is an intrinsically unstable factor; and, although risk is not directly
factored in, risk is indirectly factored in because it is reflected in the market price of the stock.
In the market, keeping an eye on the stock price and the most recent dividend is simple, but
calculating the dividend growth rate is more difficult. There are two methods for estimating
this: using historical data from the firm to calculate an average growth rate, or using analyst
estimates regarding earnings and dividend distribution.

6. What are the advantages of using the SML approach to finding the cost of equity capital?
What are the disadvantages? What specific pieces of information are needed to use this
method? Are all of these variables observable, or do they need to be estimated? What are
some of the ways in which you could get these estimates?

The incorporation of a stock's particular risk and the Security Market Line (SML) approach's
wider application than the Dividend Discount Model are two of its primary advantages. The
SML technique does not rely on assumptions about a firm's payouts. The SML technique does
have some disadvantages, though, in that it depends on historical data to estimate three
parameters: beta, predicted market return, and risk-free rate. Usually, the observable
short-term T-bill yields are used to estimate the risk-free rate. The market risk premium, on the
other hand, is derived from historical risk premiums and is thus unobservable. The estimation
 of the stock beta, which is similarly not visible, is based on projections made by investment
firms and analysts or on historical averages of the business and market returns.

7. How do you determine the appropriate cost of debt for a company? Does it make a difference
if the company’s debt is privately placed as opposed to being publicly traded? How would you
estimate the cost of debt for a firm whose only debt issues are privately held by institutional
investors?

The current interest rate that a business would have to pay on new debt issue is the accurate
post-tax cost of debt for that business. By examining the Yield to Maturity (YTM) of the
company's current bonds, this may be ascertained with accuracy. The firm can estimate the
cost of debt for privately placed debt in three ways: (a) by comparing with other businesses in
the same risk category; (b) by examining the average debt cost for businesses with the same
credit rating; or (c) by consulting analysts and investment bankers. Accurately estimating the
cost gets increasingly difficult for businesses with several public debt issues, though, because
each issue has a different yield and no two are ever exactly the same.

8. Suppose Tom O’Bedlam, president of Bedlam Products, Inc., has hired you to determine the
firm’s cost of debt and cost of equity capital.
a. The stock currently sells for $50 per share, and the dividend per share will probably
be about $5. Tom argues, “It will cost us $5 per share to use the stockholders’ money
this year, so the cost of equity is equal to 10 percent (= $5/50).” What’s wrong with
this conclusion?

This simply takes into account the necessary return on equity's dividend yield
component.

b. Based on the most recent financial statements, Bedlam Products’s total liabilities are
$8 million. Total interest expense for the coming year will be about $1 million. Tom
therefore reasons, “We owe $8 million, and we will pay $1 million interest.
Therefore, our cost of debt is obviously $1 million/8 million = .125, or 12.5%.” What’s
wrong with this conclusion?

Not the yield to maturity that is pledged, but the present yield. Moreover, taxes are not
taken into account and the calculation is based on the liability's book value.

c. Based on his own analysis, Tom is recommending that the company increase its use
of equity financing because “Debt costs 12.5 percent, but equity costs only 10
percent; thus equity is cheaper.” Ignoring all the other issues, what do you think
about the conclusion that the cost of equity is less than the cost of debt?

With the possible exception of the uncommon scenario in which a firm's assets have a
negative beta, equity is by nature riskier than debt. The cost of equity is higher than the
cost of debt because of this. When taxes are taken into account, it becomes evident
that, in this instance, the cost of equity outweighs the cost of debt at fair tax rates.

9. Both Dow Chemical Company, a large natural gas user, and Superior Oil, a major natural gas
producer, are thinking of investing in natural gas wells near Houston. Both companies are all
 equity financed. Dow and Superior are looking at identical projects. They’ve analyzed their
respective investments, which would involve a negative cash flow now and positive expected
cash flows in the future. These cash flows would be the same for both firms. No debt would
be used to finance the projects. Both companies estimate that their projects would have a
net present value of $1 million at an 18 percent discount rate and a −$1.1 million NPV at a 22
percent discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The
expected risk premium on the market is 8 percent, and risk-free bonds are yielding 12
percent. Should either company proceed? Should both? Explain.

The required rate of return, denoted as RSup, is calculated as 0.12 + 0.75(0.08), which equals
0.18 or 18.00%. Both companies should proceed with the investment. The correct discount
rate for a project is determined by the project's risk, not the investing company's identity.
Superior, being more specialized in this field, represents a more accurate benchmark.
Consequently, its cost of capital, which is 18 percent, should be applied. At this cost of capital,
the project presents a net present value (NPV) of $1 million, irrespective of the company
undertaking it.

10. Under what circumstances would it be appropriate for a firm to use different costs of capital
for its different operating divisions? If the overall firm WACC were used as the hurdle rate
for all divisions, would the riskier divisions or the more conservative divisions tend to get
most of the investment projects? Why? If you were to try to estimate the appropriate cost of
capital for different divisions, what problems might you encounter? What are two
techniques you could use to develop a rough estimate for each division’s cost of capital?

When multiple operational divisions of the same firm fall into radically different risk categories,
it is best to use separate cost of capital rates for each division rather than a single rate for the
entire company. Funding allocation can become unbalanced when a consistent hurdle rate is
used, especially in favor of higher-risk divisions. These divisions may be profitable according to
the universal hurdle rate, but as their location below the Security Market Line (SML) suggests,
they may not be profitable according to a risk-adjusted scale. Lack of market-traded securities
unique to a division makes it difficult to measure market views of its risk, which is a typical
difficulty in assessing a division's cost of capital.

Questions and Problems

1.The Tribiani Co. just issued a dividend of $2.90 per share on its common stock. The company is
expected to maintain a constant 4.5 percent growth rate in its dividends indefinitely. If the stock sells
for $56 a share, what is the company’s cost of equity?

RE = [$2.90(1.045)/$56] + .045= .0991

4. Suppose Wacken, Ltd., just issued a dividend of $2.73 per share on its common stock. The company
paid dividends of $2.31, $2.39, $2.48, and $2.58 per share in the last four years. If the stock currently
sells for $43, what is your best estimate of the company’s cost of equity capital using the arithmetic
average growth rate in dividends? What if you use the geometric average growth rate?

g1 = ($2.39 – 2.31)/$2.31 = .0346

g3 = ($2.58 – 2.48)/$2.48 = .0403

g4 = ($2.73 – 2.58)/$2.58 = .0581

g = (.0346 + .0377 + .0403 + .0581)/4 = .04269

RE = [$2.73(1.04269)/$43] + .04269 = .1089

$2.73 = $2.31(1 + g) 4 = .04265

RE = [$2.73(1.04265)/$43] + .04265 = .1088

5. Savers has an issue of preferred stock with a stated dividend of $3.85 that just sold for $87 per
share. What is the bank’s cost of preferred stock?

RP = $3.85/$87= .0443

6. Sunrise, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with 23
years to maturity that is quoted at 96 percent of face value. The issue makes semiannual payments
and has an embedded cost of 5 percent annually. What is the company’s pretax cost of debt? If the
tax rate is 21 percent, what is the aftertax cost of debt?

P0 = $960 = $25(PVIFAR%,46) + $1,000(PVIFR%,46)

R = 2.652% YTM = 2 × 2.652% YTM = 5.30%

RD = .0530(1 – .21)= .0419

9. Ninecent Corporation has a target capital structure of 70 percent common stock, 5 percent
preferred stock, and 25 percent debt. Its cost of equity is 11 percent, the cost of preferred stock is 5
percent, and the pretax cost of debt is 6 percent. The relevant tax rate is 23 percent.

a. What is the company’s WACC?

WACC = .70(.11) + .05(.05) + .25(.06)(1 – .23) = .0911

b. The company president has approached you about the company’s capital structure. He wants to
know why the company doesn’t use more preferred stock financing because it costs less than debt.
What would you tell the president?

RD = .06(1 – .23) = .0462

10. Brannan Manufacturing has a target debt-equity ratio of .35. Its cost of equity is 11 percent, and
its pretax cost of debt is 6 percent. If the tax rate is 21 percent, what is the company’s WACC?

WACC = .11(1/1.35) + .06(.35/1.35)(1 – .21) = .0938

11. Fama’s Llamas has a weighted average cost of capital of 8.4 percent. The company’s cost of equity
is 11 percent, and its pretax cost of debt is 5.8 percent. The tax rate is 25 percent. What is the
company’s target debt-equity ratio?

0840(V/E) = .11 + .058(.75)(D/E)

.0405(D/E) = .026 D/E = .6420

15. Given the following information for Lightning Power Co., find the WACC. Assume the company’s
tax rate is 21 percent.

MVD = 12,000($1,000)(1.05) = $12,600,000

MVE = 575,000($81) = $46,575,000

MVP = 30,000($94) = $2,820,000

V = $12,600,000 + 46,575,000 + 2,820,000= $61,995,000

RE = .032 + 1.04(.07) = .1048

P0 = $1,050 = $23(PVIFAR%,50) + $1,000(PVIFR%,50)

R = 2.136%

YTM = 2.136% × 2= 4.27%

RD = (1 – .21)(.0427) = .0338

RP = $3.40/$94= .0362

WACC = .0338($12,600,000/$61,995,000) + .1048($46,575,000/$61,995,000) +

17. The T-bill rate is 4 percent, and the expected return on the market is 12 percent.

a. Which projects have a higher expected return than the firm’s 12 percent cost of capital?

Projects Y and Z.

b. Which projects should be accepted?

E[W] = .04 + .83(.12 – .04) = .1064 > .094, so reject

W E[X] = .04 + .92(.12 – .04) = .1136 < .116, so accept

X E[Y] = .04 + 1.09(.12 – .04) = .1272 < .129, so accept

Y E[Z] = .04 + 1.35(.12 – .04) = .1480 > .141, so reject Z

c. Which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital were
used as a hurdle rate?

It would be inappropriate to reject Project X and to approve Project Z.

18. Suppose your company needs $43 million to build a new assembly line. Your target debt-equity
ratio is .75. The flotation cost for new equity is 6 percent, but the flotation cost for debt is only 2
percent. Your boss has decided to fund the project by borrowing money because the flotation costs
are lower and the needed funds are relatively small.
a. What do you think about the rationale behind borrowing the entire amount?

In addition to the debt cost, he has to consider the weighted average flotation cost.

b. What is your company’s weighted average flotation cost, assuming all equity is raised externally?

fT = .02(.75/1.75) + .06(1/1.75)= .0429

c. What is the true cost of building the new assembly line after taking flotation costs into account?
Does it matter in this case that the entire amount is being raised from debt?

Amount raised = $43,000,000/(1 – .0429)= $44,925,373