gitman_12e_525314_IM_ch11r_2

Part 4 Long-Term Financial Decisions Chapters in this Part Chapter 11

The Cost of Capital

Chapter 12

Leverage and Capital Structure

Chapter 13

Dividend Policy

Integrative Case 4: O’Grady Apparel Company

Chapter 11 The Cost of Capital  Instructor’s Resources Overview This chapter introduces the student to an important financial concept, the cost of capital. The mechanics of computing the sources of capital-debt, preferred stock, common stock, and retained earnings are reviewed. The relationship between the cost of capital and both the firm’s financing activities and capital investment decisions is explored. In the framework of a target capital structure, the weighted average cost of capital is then applied to capital investment decisions. Students are encouraged to devote time and effort to learning Chapter 11’s materials because acceptable projects encountered in their professional life or investment decisions made in their personal life will be correct if they earn a return higher than the cost of capital.

Study Guide Suggested Study Guide examples for classroom presentation: Example

Topic

7

Weighted average cost of capital Marginal cost of capital schedule

8

 Suggested Answer to Chapter Opening Critical Thinking Question As part of the 2007 refinancing, UAL was able to withdraw approximately $2.5 billion in assets from a collateral pool. What does this allow the company to do in the future? Unless restricted by the new line of credit—and in this case the withdrawn collateral was not restricted— the company can use the freed-up assets to secure new financing, providing a source of additional liquidity if needed.

 Answers to Review Questions 1. The cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital provides a benchmark against which the potential rate of return on an investment is compared. 2. Holding business risk constant assumes that the acceptance of a given project leaves the firm’s ability to meet its operating expenses unchanged. Holding financial risk constant assumes that the acceptance of a given project leaves the firm’s ability to meet its required financing expenses unchanged. By doing this it is possible to more easily calculate the firm’s cost of capital, which is a factor taken into consideration in evaluating new projects. 3. The cost of capital is measured on an after-tax basis in order to be consistent with the capital budgeting framework. The only component of the cost of capital that actually requires a tax adjustment is the cost of debt, since interest on debt is treated as a tax-deductible expenditure. Measuring the cost of debt on an after-tax basis reduces the cost. The use of the weighted average cost of capital is recommended over the cost of the source of funds to be used for the project. The interrelatedness of financing decisions assuming the presence of a target capital structure is reflected in the weighted average cost of capital. 4. In order to make any such financing decision, the overall cost of capital must be considered. This results from the interrelatedness of financing activities. For example, a firm raising funds with debt today may need to use equity the next time, and the cost of equity will be related to the overall capital structure, including debt, of the firm at the time. 5. The net proceeds from the sale of a bond are the funds received from its sale after all underwriting and brokerage fees have been paid. A bond sells at a discount when the rate of interest currently paid on similar-risk bonds is above the bond’s coupon rate. Bonds sell at a premium when their coupon rate is above the prevailing market rate of interest on similar-risk bonds. Flotation costs are fees charged by investment banking firms for their services in assisting in selling the bonds in the primary market. These costs reduce the total proceeds received by the firm since the fees are paid from the bond funds. 6. The three approaches to finding the before-tax cost of debt are: 1. The quotation approach that uses the current market value of a bond to determine the yield-tomaturity on the bond. If the market price of the bond is equal to its par value the yield-tomaturity is the same as the coupon rate. 2. The calculation approach finds the before-tax cost of debt by calculating the internal rate of return (IRR) on the bond cash flows.

22  Gitman • Principles of Managerial Finance, Twelfth Edition

3. The approximation approach uses the following formula to approximate the before-tax cost of the debt. rd =

[($1,000 − N d )] n ( N d + $1,000) 2

I+

I = the annual interest payment in dollars Nd = the net proceeds from the sale of a bond n = the term of the bond in years The first part of the numerator of the equation represents the annual interest, and the second part represents the amortization of any discount or premium; the denominator represents the average amount borrowed.

where:

7. The before-tax cost is converted to an after-tax debt cost (ri) by using the following equation: ri = rd × (1 − T), where T is the firm’s tax rate.

Chapter 11 The Cost of Capital  23

8. The cost of preferred stock is found by dividing the annual preferred stock dividend by the net proceeds from the sale of the preferred stock. The formula is: rp = where:

Dp Np

Dp = the annual dividend payment in dollars Np = the net proceeds from the sale of the preferred stock

9. The assumptions underlying the constant growth valuation (Gordon) model are: a. The value of a share of stock is the PV of all dividends expected to be paid over its life. b. The rate of growth of dividends and earnings is constant, which means that the firm has a fixed payout ratio. c. Firms perceived by investors to be equally risky have their expected earnings discounted at the same rate. 10. The cost of retained earnings is technically less than the cost of new common stock, since by using retained earnings (cash) the firm avoids underwriting costs, as well as possible underpricing costs. 11. The weighted average cost of capital (WACC), ra, is an average of the firm’s cost of long-term financing. It is calculated by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure 12. Using target capital structure weights, the firm is trying to develop a capital structure that is optimal for the future, given present investor attitudes toward financial risk. Target capital structure weights are most often based on desired changes in historical book value weights. Unless significant changes are implied by the target capital structure weights, little difference in the weighted marginal cost of capital results from their use. 13. The weighted marginal cost of capital (WMCC) is the firm’s weighted average cost of capital associated with its next dollar of total new financing. The WMCC is of interest to managers because it represents the current cost of funds should the firm need to go to the capital markets for new financing. The WMCC schedule increases as a firm goes to the market for larger sums of money because the risk exposure to the supplier of funds of the borrowing firm’s risk increases to the point that the lender must increase their interest rate to justify the additional risk. 14. The investment opportunities schedule (IOS) is a ranking of the firm’s investment opportunities from the best (highest returns) to worst (lowest returns). The schedule is structured so that it is a decreasing function of the level of total investment. The downward direction of the schedule is due to the benefit of selecting the projects with the greatest return first. The look also helps in the identification of the projects that have an IRR in excess of the cost of capital, and to see which projects can be accepted before the firm exceeds it limited capital budget. 15. All projects to the left of the cross-over point of the IOS and the WMCC lines have an IRR greater than the firm’s cost of capital. Undertaking all of these projects will maximize the owner’s wealth. Selecting any projects to the right of the cross-over point will decrease the owner’s wealth. In practice managers normally do not invest to the point where IOS = WMCC due to the self-imposed capital budgeting constraint most firms follow.

24  Gitman • Principles of Managerial Finance, Twelfth Edition

 Suggested Answer to Critical Thinking Question for Focus on Practice Box Why might a company use EVA® as a measure of its performance in addition to the standard accounting measures? In most circumstances a company is very interested in its stock price. Many investors make their stock selection based on a variety of company performance indicators, including earnings per share, revenue growth, free cash flow, and so on. It only makes sense that if the EVA ® for the company produces a positive comparison with other companies, the company would consider touting that statistic.

 Suggested Answer to Critical Thinking Question for Focus on Ethics Box What effect would an increased cost of capital have on a firm’s future investments? Economic theory confirms that an inverse relationship exists between investment and the cost of capital. If the cost of investment capital rises, less of it will be used. In addition to the potential decrease in available capital, the higher cost of capital will increase the hurdle rate used to evaluate potential projects, with the likelihood that fewer potential projects will pass acceptability criteria based on the hurdle rate.

 Answers to Warm-Up Exercises E11-1.

Weighted average cost of capital

Answer: ra = (0.35 × 0.08) + (0.65 × 0.13) = 0.1125 = 11.25% E11-2.

Net PV

Answer: A financial calculator can be used to determine the IRR. Set the calculator to 2 P/YR (2 periods per year compounding). PV = 19,600 I = 8%/year N = 10 period PMT = −1,600 FV = −20,000 Solve for I IRR = 8.30% E11-3.

Cost of preferred stock

Answer: The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock. rp = D p ÷ N p rp = (0.15 × $35) ÷ ($35 – $3) rp = $5.25 ÷ $32 = 16.4%

Chapter 11 The Cost of Capital  25

E11-4.

Cost of common stock equity

Answer: The cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current price of the stock and adding the expected growth rate. rs = (D1 ÷ P0) + g rs = ($6.50 ÷ $78) + 7% = 15.33% E11-5.

Weighted average cost of capital

Answer: ra = (0.55 × 0.067) + (0.10 × 0.092) + (0.35 × 0.106) = 0.0832 = 8.32%

 Solutions to Problems P11-1. LG 1: Concept of cost of capital Basic a. The firm is basing its decision on the cost to finance a particular project rather than the firm’s combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions. b. ra = wd rd + we re ra = 0.40 (7%) + 0.60(16%) ra = 2.8% + 9.6% ra = 12.4% c. Reject project 263. Accept project 264. d. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as a criterion provides better decisions because it takes into consideration the long-run interrelationship of financing decisions. P11-2. LG 2: Cost of debt using both methods Intermediate a. Net proceeds: Nd = $1,010 − $30 Nd = $980 b.

Cash flows:

T 0 1–15 15

c.

CF $ 980 −120 −1,000

Cost to maturity:  n I   M  +  B° =  ∑ t n  t =1 ( 1 + r )   ( 1 + r )   15 −$120   −$1,000  +  $980 =  ∑ t 15  t =1 ( 1 + r )   ( 1 + r ) 

26  Gitman • Principles of Managerial Finance, Twelfth Edition

Step 1: Try 12% V = 120 × (6.811) + 1,000 × (0.183) V = 817.32 + 183 V = $1,000.32 (Due to rounding of the PVIF table values, the value of the bond is 32 cents greater than expected. At the coupon rate, the value of a $1,000 face value bond is $1,000.) Try 13%: V = 120 × (6.462) + 1,000 × (0.160) V = 775.44 + 160 V = $935.44 The cost to maturity is between 12% and 13%. Step 2: $1,000.32 − $935.44 = $64.88 Step 3: $1,000.32 − $980.00 = $20.32

d.

Step 4: $20.32 ÷ $64.88 = 0.31 Step 5: 12 + 0.31 = 12.31% = before-tax cost of debt 12.31 (1 − 0.40) = 7.39% = after-tax cost of debt Calculator solution: 12.30% Approximate before-tax cost of debt $1,000 − N d n rd = N d + $1,000 2 $1,000 − Nd I+ $1,000 − $980 ) ( n $120 + rd = 15 N d + $1,000 rd = ( $980 + $1,000 ) 2 2 rd = $121.33 ÷ $990,00 rd = 12.26% rd =

e.

($1,000 − $980) 15 ($980 + $1,000) 2

$120 +

Approximate after-tax cost of debt = 12.26% × (1 − 0.4) = 7.36% The interpolated cost of debt is closer to the actual cost (12.2983%) than using the approximating equation. However, the short cut approximation is fairly accurate and expedient in the absence of a financial calculator.

Chapter 11 The Cost of Capital  27

P11-3

LG2: Before-tax cost of debt and after-tax cost of debt Easy a. Use the model: PV = $ annual coupon interest (PVIFA) + par value (PVIF) Solving for the discount rate N = 10, PV = – 930 (an expenditure), PMT = 0.6(1000) = 60, FV = 1000 b. Use the model: After-tax cost of debt = before-tax cost of debt × (1 – tax bracket) 7.0% ( 1 – 0.2) = 5.6%

P11-4. LG 2: Cost of debt–using the approximation formula: Basic

rd =

$1,000 − N d n  ri = rd × (1 − T) N d + $1,000 2

I+

Bond A

rd =

$1,000 − $955 $92.25 20 = = 9.44% $955 + $1,000 $977.50 2

$90 +

ri = 9.44% × (1 − 0.40) = 5.66% Bond B

rd =

$1,000 − $970 $101.88 16 = = 10.34% $970 + $1,000 $985 2

$100 +

ri = 10.34% × (1 − 0.40) = 6.20% Bond C

rd =

$1,000 − $955 $123 15 = = 12.58% $955 + $1,000 $977.50 2

$120 +

ri = 12.58% × (1 − 0.40) = 7.55% Bond D

rd =

$1,000 − $985 $90.60 25 = = 9.13% $985 + $1,000 $992.50 2

$90 +

28  Gitman • Principles of Managerial Finance, Twelfth Edition

ri = 9.13% × (1 − 0.40) = 5.48%

Bond E

rd =

$1,000 − $920 $113.64 22 = = 11.84% $920 + $1,000 $960 2

$110 +

ri = 11.84% × (1 − 0.40) = 7.10% P11-5. LG 2: Cost of debt using the approximation formula Intermediate

rd =

$1,000 − N d n  ri = rd × (1 − T) N d + $1,000 2

I+

Alternative A rd =

$1,000 − $1,220 $76.25 16 = = 6.87% $1,220 + $1,000 $1,110 2

$90 +

ri = 6.87% × (1 − 0.40) = 4.12% Alternative B rd =

$1,000 − $1,020 $66.00 5 = = 6.54% $1,020 + $1,000 $1,010 2

$70 +

ri = 6.54% × (1 − 0.40) = 3.92% Alternative C rd =

$1,000 − $970 $64.29 7 = = 6.53% $970 + $1,000 $985 2

$60 +

ri = 6.53% × (1 − 0.40) = 3.92% Alternative D rd =

$1,000 − $895 $60.50 10 = = 6.39% $895 + $1,000 $947.50 2

$50 +

ri = 6.39% × (1 − 0.40) = 3.83%

Chapter 11 The Cost of Capital  29

P11-6. LG 2: After-tax cost of debt Intermediate a. Since the interest on the boat loan is not tax deductible, its after-tax cost equals its stated cost of 8%. b. Since the interest on the second mortgage is tax deductible, its after-tax cost is found by multiplying the before-tax cost of debt by (1 – tax rate). Being in the 28% tax bracket, the after-tax cost of debt is 6.6% (9.2 (1 – 0.28)). c. Home equity loan has a lower after-tax cost. However, using the second home mortgage does put the Starks at risk of losing their home if they are unable to make the mortgage payments. P11-7. LG 2: Cost of preferred stock: rp = Dp ÷ Np Basic $12.00 = 12.63% a. rp = $95.00 b.

rp =

$10.00 = 11.11% $90.00

P11-8. LG 2: Cost of preferred stock: rp = Dp ÷ Np Basic Preferred Stock A B C D E

rp rp rp rp rp

= = = = =

Calculation $11.00 ÷ $92.00 3.20 ÷ 34.50 5.00 ÷ 33.00 3.00 ÷ 24.50 1.80 ÷ 17.50

= = = = =

11.96% 9.28% 15.15% 12.24% 10.29%

30  Gitman • Principles of Managerial Finance, Twelfth Edition

P11-9. LG 3: Cost of common stock equity–capital asset pricing model (CAPM) Intermediate rs = RF + [b × (rm − RF)] rs = 6% + 1.2 × (11% − 6%) rs = 6% + 6% rs = 12% a. Risk premium = 6% b. Rate of return = 12% c. After-tax cost of common equity using the CAPM = 12% P11-10. LG 3: Cost of common stock equity: kn =

D1 + g Nn

Intermediate D 2009 = FVIFk %,4 a. g = D 2005 $3.10 g= = 1.462 $2.12 From FVIF table, the factor closest to 1.462 occurs at 10% (i.e., 1.464 for 4 years). Calculator solution: 9.97% b. Nn = $52 (given in the problem) D2010 +g c. rr = P0 $3.40 + 0.10 = 15.91% $57.50 D rr = 2010 + g Nn

rr = d.

rr =

$3.40 + 0.10 = 16.54% $52.00

P11-11. LG 3: Retained earnings versus new common stock Intermediate rr =

D1 D1 + g     rn = +g P0 Nn

Chapter 11 The Cost of Capital  31

Firm A

Calculation rr = ($2.25 ÷ $50.00) + 8% = 12.50% rn = ($2.25 ÷ $47.00) + 8% = 12.79%

B

rr = ($1.00 ÷ $20.00) + 4% = 9.00% rn = ($1.00 ÷$18.00) + 4% = 9.56%

C

rr = ($2.00 ÷ $42.50) + 6% = 10.71% rn = ($2.00 ÷ $39.50) + 6% = 11.06%

D

rr = ($2.10 ÷ $19.00) + 2% = 13.05% rn = ($2.10 ÷ $16.00) + 2% = 15.13%

P11-12. LG 2, 4: Effect of tax rate on WACC Intermediate a.

WACC = (0.30)(11%)(1 – 0.40) + (0.10)(9%) + (0.60)(14%) WACC = 1.98% + 0.9% + 8.4% WACC = 11.28%

b.

WACC = (0.30)(11%)(1 – 0.35) + (0.10)(9%) + (0.60)(14%) WACC = 2.15% + 0.9% + 8.4% WACC = 11.45%

c.

WACC = (0.30)(11%)(1 – 0.25) + (0.10)(9%) + (0.60)(14%) WACC = 2.48% + 0.9% + 8.4% WACC = 11.78%

d.

As the tax rate decreases, the WACC increases due to the reduced tax shield from the taxdeductible interest on debt.

32  Gitman • Principles of Managerial Finance, Twelfth Edition

P11-13. LG 4: WACC–book weights Basic a. Type of Capital Book Value L-T debt $700,000 Preferred stock 50,000 Common stock 650,000 $1,400,000

Weight 0.500 0.036 0.464 1.000

Cost 5.3% 12.0% 16.0%

Weighted Cost 2.650% 0.432% 7.424% 10.506%

b. The WACC is the rate of return that the firm must receive on long-term projects to maintain the value of the firm. The cost of capital can be compared to the return for a project to determine whether the project is acceptable. P11-14. LG 4: WACC–book weights and market weights Intermediate a. Book value weights: Type of Capital Book Value Weight L-T debt $4,000,000 0.784 Preferred stock 40,000 0.008 Common stock 1,060,000 0.208 $5,100,000 b. Market value weights: Type of Capital Market Value L-T debt $3,840,000 Preferred stock 60,000 Common stock 3,000,000 $6,900,000 c.

Weight 0.557 0.009 0.435

Cost 6.00% 13.00% 17.00%

Weighted Cost 4.704% 0.104% 3.536% 8.344%

Cost 6.00% 13.00% 17.00%

Weighted Cost 3.342% 0.117% 7.395% 10.854%

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

P11-15. LG 4: WACC and target weights Intermediate a.

Historical market weights: Type of Capital Weight L-T debt 0.25 Preferred stock 0.10 Common stock 0.65

Cost 7.20% 13.50% 16.00%

Weighted Cost 1.80% 1.35% 10.40% 13.55%

Chapter 11 The Cost of Capital  33

b.

c.

Target market weights: Type of Capital Weight L-T debt 0.30 Preferred stock 0.15 Common stock 0.55

Cost 7.20% 13.50% 16.00%

Weighted Cost 2.160% 2.025% 8.800% 12.985%

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

P11-16. LG 4, 5: Cost of capital and break point Challenge a. Cost of retained earnings rr = b.

Cost of new common stock rs =

c.

$1.26(1 + 0.06) $1.34 + 0.06 = = 3.35% + 6% = 9.35% $40.00 $40.00

$1.26(1 + 0.06) $1.34 + 0.06 = = 4.06% + 6% = 10.06% $40.00 − $7.00 $33.00

Cost of preferred stock rp =

$2.00 $2.00 = = 9.09% $25.00 − $3.00 $22.00

$1,000 − $1,175 $65.00 5 rd = = = 5.98% $1,175 + $1,000 $1,087.50 2 ri = 5.98% × (1 − 0.40) = 3.59% $100 +

d.

$4,200,000 − ($1.26 × 1,000,000) $2,940,000 = = $5,880,000 0.50 0.50

e.

BPcommon equity =

f.

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(9.35%) WACC = 1.436 + 0.909 + 4.675 WACC = 7.02% This WACC applies to projects with a cumulative cost between 0 and $5,880,000.

g.

WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(10.06%) WACC = 1.436 + 0.909 + 5.030 WACC = 7.375% This WACC applies to projects with a cumulative cost over $5,880,000.

34  Gitman • Principles of Managerial Finance, Twelfth Edition

P11-17. LG 2, 3, 4, 5: Calculation of specific costs, WACC, and WMCC Challenge a. Cost of debt: (approximate)

rd =

rd =

($1,000 − N d ) n ( N d + $1,000) 2

I+

($1,000 − $950) $100 + $5 10 = = 10.77% ($950 + $1,000) $975 2

$100 +

ri = 10.77 × (l − 0.40) ri = 6.46% Cost of preferred stock: rp = rp =

Dp Np

$8 = 12.70% $63

Cost of common stock equity: rs = g=

D 2009 = FVIFr %,4 D 2005

g=

$3.75 = 1.316 $2.85

D1 +g P0

From FVIF table, the factor closest to 1.316 occurs at 7% (i.e., 1.311 for 4 years). Calculator solution: 7.10% rr =

$4.00 + 0.07 = 15.00% $50.00

Cost of new common stock equity: rn =

$4.00 + 0.07 = 16.52% $42.00

Chapter 11 The Cost of Capital  35

b.

Breaking point = BPcommon equity =

AFj Wj

[$7,000,000 × (1 − 0.6* )] = $5,600,000 0.50

Between $0 and $5,600,000, the cost of common stock equity is 15% because all common stock equity comes from retained earnings. Above $5,600,000, the cost of common stock equity is 16.52%. It is higher due to the flotation costs associated with a new issue of common stock. *

The firm expects to pay 60% of all earnings available to common shareholders as dividends.

c.

WACC—$0 to $5,600,000:

L-T debt 0.40 × 6.46% Preferred stock 0.10 × 12.70% Common stock 0.50 × 15.00% WACC

= = = =

2.58% 1.27% 7.50% 11.35%

d.

WACC—above $5,600,000: L-T debt 0.40 × 6.46% Preferred stock 0.10 × 12.70% Common stock 0.50 × 16.52% WACC

= = = =

2.58% 1.27% 8.26% 12.11%

P11-18. LG4: Weighted-average cost of capital Intermediate

Loan 1 Loan 2 Loan 3 Total

Rate [1]

Outstanding Loan Balance [2]

Weight [2] ÷ 64,000 = [3]

6.00% 9.00% 5.00%

$ 20,000 $12,000 $32,000 $64,000

31.25% 18.75% 50.00%

WACC [1] × [3] 1.88% 1.69% 2.50% 6.06%

36  Gitman • Principles of Managerial Finance, Twelfth Edition

John Dough should not consolidate his college loans because their weighted cost is less than the 7.2% offered by his bank. P11-19. LG 2, 3, 4, 5: Calculation of specific costs, WACC, and WMCC Challenge a. Debt: (approximate) r = d

($1,000 − N ) n ( N + $1,000) 2

I+

d

d

r =

($1,000 − $940) $80 + $3 20 = = 8.56% ($940 + $1,000) $970 2

$80 +

d

ri = rd × (1 − t) ri = 8.56% × (1 − 0.40) ri = 5.14% Preferred stock: rp = rp =

Dp Np $7.60 = 8.44% $90

Common stock: rn =

Dj +g Nn

rp =

$7.00 = 0.06 = 0.1497 = 14.97% $78

Retained earnings:

b.

rr =

D1 +g P0

rp =

$7.00 + 0.06 = 0.1378 = 13.78% $90

Breaking point = 1.

BPcommon equity

AFj Wi [ $100,000 ] = $200,000 = 0.50

Chapter 11 The Cost of Capital  37

2.

3.

Type of Capital WACC equal to or below $200,000 BP: Long-term debt Preferred stock Common stock equity WACC above $200,000 BP: Long-term debt Preferred stock Common stock equity

Target Capital Structure %

Cost of Capital Source

Weighted Cost

0.30 0.20 0.50

5.1% 1.53% 8.4% 1.68% 13.8% 6.90% WACC = 10.11%

0.30 0.20 0.50

5.1% 1.53% 8.4% 1.68% 15.0% 7.50% WACC = 10.71%

38  Gitman • Principles of Managerial Finance, Twelfth Edition

P11-20. LG 4, 5, 6: Integrative–WACC, WMCC, and IOS Challenge a. Breaking points and ranges: Source of Capital Long-term debt

Cost Range of % New Financing 6 $0−$320,000 8 $320,001 and above

Preferred stock

17

$0 and above

Common stock equity

20 24

$0−$200,000 $200,001 and above

Breaking Point $320,000 ÷ 0.40 = $800,000

Greater than $0 $200,000 ÷ 0.40 = $500,000

b.

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

c.

WACC Source of Capital (1) Debt Preferred Common

Target Proportion (2) 0.40 0.20 0.40

$500,000−$800,000

Debt Preferred Common

0.40 0.20 0.40

Greater than $800,000

Debt Preferred Common

0.40 0.20 0.40

Range of Total New Financing $0−$500,000

Range of Total New Financing $0−$800,000 Greater than $800,000 $0−$500,000 Greater than $500,000

Weighted Cost Cost % (2) × (3) (3) (4) 6 2.40% 17 3.40% 20 8.00% WACC = 13.80% 6% 2.40% 17% 3.40% 24% 9.60% WACC = 15.40% 8% 3.20% 17% 3.40% 24 9.60% WACC = 16.20%

Chapter 11 The Cost of Capital  39

d.

IOS data for graph Investment E C G A H I B D F

e.

IRR 23% 22 21 19 17 16 15 14 13

Initial Investment $200,000 100,000 300,000 200,000 100,000 400,000 300,000 600,000 100,000

Cumulative Investment $ 200,000 300,000 600,000 800,000 900,000 1,300,000 1,600,000 2,200,000 2,300,000

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

P11-21. LG 4, 5, 6: Integrative–WACC, WMCC, and IOC Challenge a. WACC: 0 to $600,000 = (0.5)(6.3%) + (0.1)(12.5%) + (0.4)(15.3%) = 3.15% + 1.25% + 6.12% = 10.52% WACC: $600,001−$1,000,000 = (0.5)(6.3%) + (0.1)(12.5%) + (0.4)(16.4%) = 3.15% + 1.25% + 6.56% = 10.96% WACC: $1,000,001 and above = (0.5)(7.8%) + (0.1)(12.5%) + (0.4)(16.4%) = 3.9% + 1.25% + 6.56% = 11.71% See Part c for the WMCC schedule.

40  Gitman • Principles of Managerial Finance, Twelfth Edition

b.

Project M should not be accepted Mirr (11.4%) ‹ Mwmcc (11.71%)

c.

d.

In this problem, Projects H, G, and K would be accepted since the IRR for these projects exceeds the WMCC. The remaining project, M, would be rejected because the WMCC is greater than the IRR.

P11-22. Ethics problem Intermediate The company would likely try to deny the claim on the basis that no damages have been sustained or proven by the claimant. The claimant would argue that the company might not be around to pay damages when the symptoms emerge and that the damage has already been done even if the symptoms are not present.

 Case Making Star Products’ Financing/Investment Decision The Chapter 11 case, Star Products, is an exercise in evaluating the cost of capital and available investment opportunities. The student must calculate the component costs of financing, long-term debt, preferred stock, and common stock equity; determine the breaking points associated with each source; and calculate the WACC. Finally, the student must decide which investments to recommend to Star Products.

Chapter 11 The Cost of Capital  41

1.

Cost of financing sources Debt: Below $450,000: ($1,000 − Nd ) n rd = ( Nd + $1,000) 2 ($1,000 − $960) $90 + 15 rd = ($960 + $1,000) 2 $92.67 rd = = 0.0946 = 9.46% $980 ri = rd × (1 − t) I+

ri = 9.46 × (1 − 0.4) ri = 5.68% Above $450,000: ri = rd × (1 − t) ri = 13.0 × (1 − 0.4) ri = 7.8% Preferred stock: Dp Np $9.80 rp = = 0.1508 = 15.08% $65 rp =

Common stock equity: $0−$1,500,000: rr =

Di +g P0

rr =

$0.96 + 0.11 = 19% $12

rr =

Di +g Nn

rr =

$0.96 + 0.11 = 21.67% $9

Above $1,500,000:

42  Gitman • Principles of Managerial Finance, Twelfth Edition

2.

Breaking points AFj Wi $450,000 = $1,500,000 BPLong-term debt = 0.30 $1,500,000 = $2,500,000 BPcommon equity = 0.60 Breaking point =

3.

Weighted average cost of capital:

1.

2.

3.

4.

Type of Capital From $0 to $1,500,000: Long-term debt Preferred stock Common stock equity

Target Capital Structure %

From $1,500,000 to $2,500,000: Long-term debt Preferred stock Common stock equity Above $2,500,000: Long-term debt Preferred stock Common stock equity

Cost of Capital Source

Weighted Cost

0.30 0.10 0.60 1.00

5.7% 1.71% 15.1% 1.51% 19.0% 11.40% WACC = 14.62%

0.30 0.10 0.60 1.00

7.8% 2.34% 15.1% 1.51% 19.0% 11.40% WACC = 15.25%

0.30 0.10 0.60 1.00

7.8% 2.34% 15.1% 1.51% 21.7% 13.02% WACC = 16.87%

Chapter 11 The Cost of Capital  43

5.

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

 Spreadsheet Exercise The answer to Chapter 11’s measurement of the cost of capital at Nova Corporation spreadsheet problem is located in the Instructor’s Resource Center at www.prenhall.com/irc.

 Group Exercises Accurately measuring the cost of capital is the topic of this chapter. The group exercise will use current information from the shadow firm to provide details for each group’s fictitious firm. The balance sheet is the source of this information and the assignment begins with an investigation into the shadow firm’s debt/equity mix. The group uses the shadow firm’s balance sheet as a guide to developing a balance sheet for their fictitious firm. Students should closely follow the sources and uses of the shadow firm’s financing. Using this balance sheet the WACC is then estimated. Groups then design a new investment opportunity, calculate its IRR, and based upon prior cost estimates make an accept/reject decision with regard to this investment opportunity.

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