Calculate the weighted average cost of capital (WACC), and discuss

LG 6 Calculate the weighted average cost of capital (WACC), and discuss

alternative weighting schemes. The firm’s WACC reflects the expected average future cost of funds over the long run. It combines the costs of specific types of capital after weighting each of them by its proportion. The theoretically pre- ferred approach uses target weights based on market values.

Opener-in-Review

The chapter opener claimed that GE’s cost of capital in late 2009 was about 5%. Suppose that GE could use $1 billion to make an investment that would generate positive cash flow of $60 million every year in perpetuity. At a 5 per- cent discount rate, what would be the value of this cash flow to investors? How much would such an investment add to GE’s market value? Now suppose that the investment actually produces just $10 million per year in perpetuity (or about 1 percent per year relative to the cost of the investment). What is the value of this investment to shareholders, and by how much would GE’s market value fall because of this investment?

Self-Test Problem (Solutions in Appendix)

LG 3 LG 4 ST9–1 Individual costs and WACC Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax bracket. Current investigation has

LG 5 LG 6 gathered the following data:

CHAPTER 9

The Cost of Capital

issue, an average discount of $30 per bond must be given. The firm must also pay flotation costs of $20 per bond.

Preferred stock The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value. The cost of issuing and selling the preferred stock is expected to be $4 per share.

Common stock The firm’s common stock is currently selling for $80 per share. The firm expects to pay cash dividends of $6 per share next year. The firm’s divi- dends have been growing at an annual rate of 6%, and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per share, and flotation costs are expected to amount to $4 per share.

Retained earnings The firm expects to have $225,000 of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

a. Calculate the individual cost of each source of financing. (Round to the nearest

0.1%.) b. Calculate the firm’s weighted average cost of capital using the weights shown in

the following table, which are based on the firm’s target capital structure propor- tions. (Round to the nearest 0.1%.)

Source of capital

Weight

Long-term debt

Preferred stock

Common stock equity

Total

c. In which, if any, of the investments shown in the following table do you recom- mend that the firm invest? Explain your answer. How much new financing is required?

Investment

Expected rate

Initial

opportunity

of return

investment

A 11.2%

$100,000 B 9.7 500,000 C 12.9 150,000 D 16.5 200,000 E 11.8 450,000 F 10.1 600,000 G 10.5 300,000

Warm-Up Exercises All problems are available in

LG 3 E9–1 A firm raises capital by selling $20,000 worth of debt with flotation costs equal to

PART 4

Risk and the Required Rate of Return

LG 4 E9–2 Your firm, People’s Consulting Group, has been asked to consult on a potential pre- ferred stock offering by Brave New World. This 15% preferred stock issue would be

sold at its par value of $35 per share. Flotation costs would total $3 per share. Calculate the cost of this preferred stock.

LG 5 E9–3 Duke Energy has been paying dividends steadily for 20 years. During that time, divi- dends have grown at a compound annual rate of 7%. If Duke Energy’s current stock

price is $78 and the firm plans to pay a dividend of $6.50 next year, what is Duke’s cost of common stock equity?

LG 6 E9–4 Weekend Warriors, Inc., has 35% debt and 65% equity in its capital structure. The firm’s estimated after-tax cost of debt is 8% and its estimated cost of equity is 13%.

Determine the firm’s weighted average cost of capital (WACC). LG 6 E9–5 Oxy Corporation uses debt, preferred stock, and common stock to raise capital. The

firm’s capital structure targets the following proportions: debt, 55%; preferred stock, 10%; and common stock, 35%. If the cost of debt is 6.7%, preferred stock costs 9.2%, and common stock costs 10.6%, what is Oxy’s weighted average cost of capital (WACC)?

Problems All problems are available in

LG 1 P9–1 Concept of cost of capital Wren Manufacturing is in the process of analyzing its investment decision-making procedures. The two projects evaluated by the firm during the past month were projects 263 and 264. The basic variables surrounding each project analysis and the resulting decision actions are summarized in the fol- lowing table.

Basic variables

Expected return

Least-cost financing

Cost (after-tax)

Don’t invest

a. Evaluate the firm’s decision-making procedures, and explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’ best interest.

b. If the firm maintains a capital structure containing 40% debt and 60% equity,

find its weighted average cost using the data in the table. c. If the firm had used the weighted average cost calculated in part b, what actions

would have been indicated relative to projects 263 and 264? d. Compare and contrast the firm’s actions with your findings in part c. Which deci-

CHAPTER 9

The Cost of Capital

LG 3 P9–2 Cost of debt using both methods Currently, Warren Industries can sell 15-year, $1,000-par-value bonds paying annual interest at a 12% coupon rate. As a result of

current interest rates, the bonds can be sold for $1,010 each; flotation costs of $30 per bond will be incurred in this process. The firm is in the 40% tax bracket.

a. Find the net proceeds from sale of the bond, N d .

b. Show the cash flows from the firm’s point of view over the maturity of the bond. c. Calculate the before-tax and after-tax costs of debt. d. Use the approximation formula to estimate the before-tax and after-tax costs of

debt. e. Compare and contrast the costs of debt calculated in parts c and d. Which

approach do you prefer? Why? Personal Finance Problem

LG 3 P9–3 Before-tax cost of debt and after-tax cost of debt David Abbot is interested in purchasing a bond issued by Sony. He has obtained the following information on

the security:

Sony bond

Par value $1,000

Tax bracket 20% Cost

Coupon interest rate 6%

Years to maturity 10

Answer the following questions. a. Calculate the before-tax cost of the Sony bond. b. Calculate the after-tax cost of the Sony bond given David’s tax bracket.

LG 3 P9–4 Cost of debt using the approximation formula For each of the following $1,000-par- value bonds, assuming annual interest payment and a 40% tax rate, calculate the after-tax cost to maturity using the approximation formula.

Discount ( ⴚ ) or Coupon Bond

Life (years)

Underwriting fee

premium ( ⴙ ) interest rate

LG 3 P9–5 The cost of debt Gronseth Drywall Systems, Inc., is in discussions with its invest-

ment bankers regarding the issuance of new 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 $1,000 par value and flotation costs will be $30 per bond. The company is taxed at a rate of 40%. Calculate the after-tax cost of financing with

PART 4

Risk and the Required Rate of Return

Coupon

Time to

Premium or

Alternative

rate

maturity (years)

discount

A 9%

16 $250 B 7 5 50 C 6 7 par D 5 10 - 75

Personal Finance Problem

LG 3 P9–6 After-tax cost of debt Rick and Stacy Stark, a married couple, are interested in pur- chasing their first boat. They have decided to borrow the boat’s purchase price of $100,000. The family is in the 28% federal income tax bracket. There are two choices for the Stark family: They can borrow the money from the boat dealer at an annual interest rate of 8%, or they could take out a $100,000 second mortgage on their home. Currently, home equity loans are at rates of 9.2%. There is no problem securing either of these two alternative financing choices.

Rick and Stacy learn that if they borrow from the boat dealership, the interest will not be tax deductible. However, the interest on the second mortgage will qualify as being tax deductible on their federal income tax return.

a. Calculate the after-tax cost of borrowing from the boat dealership. b. Calculate the after-tax cost of borrowing through a second mortgage on their

home. c. Which source of borrowing is less costly for the Stark family?

LG 4 P9–7 Cost of preferred stock Taylor Systems has just issued preferred stock. The stock has a 12% annual dividend and a $100 par value and was sold at $97.50 per share. In addition, flotation costs of $2.50 per share must be paid.

a. Calculate the cost of the preferred stock. b. If the firm sells the preferred stock with a 10% annual dividend and nets $90.00

after flotation costs, what is its cost? LG 4 P9–8 Cost of preferred stock Determine the cost for each of the following preferred

stocks.

Preferred stock

Par value

Sale price

Flotation cost Annual dividend

LG 5 P9–9 Cost of common stock equity—CAPM J&M Corporation common stock has a

beta,

b, of 1.2. The risk-free rate is 6%, and the market return is 11%. a. Determine the risk premium on J&M common stock. b. Determine the required return that J&M common stock should provide.

CHAPTER 9

The Cost of Capital

LG 5 P9–10 Cost of common stock equity Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently selling for $57.50. The firm expects to pay

a $3.40 dividend at the end of the year (2013). The dividends for the past 5 years are shown in the following table.

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 2008 to 2012. b. Determine the net proceeds, N n , that the firm will actually receive. c. Using the constant-growth valuation model, determine the cost of retained earn-

ings, r r . d. Using the constant-growth valuation model, determine the cost of new common

stock, r n . LG 5 P9–11 Retained earnings versus new common stock Using the data for each firm shown

in the following table, calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model.

Projected

Underpricing Flotation cost Firm

Current market

Dividend

dividend per

price per share

growth rate

share next year

per share per share

$2.00 $1.00 B 20.00 4 1.00 0.50 1.50 C 42.50 6 2.00 1.00 2.00 D 19.00 2 2.10 1.30 1.70

LG 3 LG 4 P9–12 The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect LG 5 LG

on its cost of capital of the rate at which the company pays taxes. The firm wishes to 6 maintain a capital structure of 30% debt, 10% preferred stock, and 60% common

stock. The cost of financing with retained earnings is 14%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 11%. Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c.

a. Tax rate = 40% b. Tax rate = 35% c. Tax rate = 25% d. Describe the relationship between changes in the rate of taxation and the

PART 4

Risk and the Required Rate of Return

LG 6 P9–13 WACC—Book weights Ridge Tool has on its books the amounts and specific (after-tax) costs shown in the following table for each source of capital.

Source of capital

Book value

Individual cost

Long-term debt

Preferred stock

Common stock equity

a. Calculate the firm’s weighted average cost of capital using book value weights. b. Explain how the firm can use this cost in the investment decision-making

process.

LG 6 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

Preferred stock

Common stock equity

a. Calculate the weighted average cost of capital using book value weights. b. Calculate the weighted average cost of capital using market value weights. c. Compare the answers obtained in parts a and b. Explain the differences.

LG 6 P9–15 WACC and target weights After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value

weights shown in the following table.

Target market

Source of capital

value weight

Long-term debt

Preferred stock

Common stock equity

Total

The cost of debt is estimated to be 7.2%; the cost of preferred stock is estimated to be 13.5%; the cost of retained earnings is estimated to be 16.0%; and the cost of new common stock is estimated to be 18.0%. All of these are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amount

CHAPTER 9

The Cost of Capital

a. Calculate the weighted average cost of capital on the basis of historical market

value weights. b. Calculate the weighted average cost of capital on the basis of target market value

weights. c. Compare the answers obtained in parts a and b. Explain the differences.

LG 3 LG 4 P9–16 Cost of capital Edna Recording Studios, Inc., reported earnings available to LG

LG common stock of $4,200,000 last year. From those earnings, the company paid a 5 6 dividend of $1.26 on each of its 1,000,000 common shares outstanding. The capital

structure of the company includes 40% debt, 10% preferred stock, and 50% common stock. It is taxed at a rate of 40%.

a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the company’s cost of retained earnings financing?

b. If underpricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the company’s cost of new common stock financing?

c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate cost of debt financing.

e. What is the WACC?

LG 3 LG 4 P9–17 Calculation of individual costs and WACC Dillon Labs has asked its financial LG

manager to measure the cost of each specific type of capital as well as the weighted 5 LG 6 average cost of capital. The weighted average cost is to be measured by using the fol- lowing weights: 40% long-term debt, 10% preferred stock, and 50% common stock

equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%. Debt The firm can sell for $980 a 10-year, $1,000-par-value bond paying

annual interest at a 10% coupon rate. A flotation cost of 3% of the par value is required in addition to the discount of $20 per bond.

Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.

Common stock The firm’s common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2013) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table.

Year

Dividend

PART 4

Risk and the Required Rate of Return

It is expected that to attract buyers, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in flotation costs. Dividend payments are expected to continue at 60% of earnings. (Assume that r r = r s .)

a. Calculate the after-tax cost of debt. b. Calculate the cost of preferred stock. c. Calculate the cost of common stock. d. Calculate the WACC for Dillon Labs.

Personal Finance Problem

LG 6 P9–18 Weighted average cost of capital John Dough has just been awarded his degree in business. He has three education loans outstanding. They all mature in 5 years and can be repaid without penalty any time before maturity. The amounts owed on each loan and the annual interest rate associated with each loan are given in the following table.

Annual

Loan

Balance due

interest rate

John can also combine the total of his three debts (that is, $64,000) and create a consolidated loan from his bank. His bank will charge a 7.2% annual interest rate for a period of 5 years.

Should John do nothing (leave the three individual loans as is) or create a con- solidated loan (the $64,000 question)?

LG 3 LG 4 P9–19 Calculation of individual costs and WACC Lang Enterprises is interested in meas- LG

uring its overall cost of capital. Current investigation has gathered the following 5 LG 6 data. The firm is in the 40% tax bracket.

Debt The firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $30 per bond would have to be given. The firm also must pay flotation costs of $30 per bond.

Preferred stock The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing and selling the preferred stock is expected to be $5 per share. Preferred stock can be sold under these terms.

Common stock The firm’s common stock is currently selling for $90 per share. The firm expects to pay cash dividends of $7 per share next year. The firm’s divi- dends have been growing at an annual rate of 6%, and this growth is expected to continue into the future. The stock must be underpriced by $7 per share, and flotation costs are expected to amount to $5 per share. The firm can sell new common stock under these terms.

Retained earnings When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners. It expects to have available

CHAPTER 9

The Cost of Capital

are exhausted, the firm will use new common stock as the form of common stock equity financing.

a. Calculate the after-tax cost of debt. b. Calculate the cost of preferred stock. c. Calculate the cost of common stock. d. Calculate the firm’s weighted average cost of capital using the capital structure

weights shown in the following table. (Round answer to the nearest 0.1%.)

Source of capital

Weight

Long-term debt

Preferred stock

Common stock equity

Total

LG 6 P9–20 Weighted average cost of capital American Exploration, Inc., a natural gas pro- ducer, is trying to decide whether to revise its target capital structure. Currently it

targets a 50–50 mix of debt and equity, but it is considering a target capital structure with 70% debt. American Exploration currently has 6% after-tax cost of debt and a 12% cost of common stock. The company does not have any preferred stock out- standing.

a. What is American Exploration’s current WACC? b. Assuming that its cost of debt and equity remain unchanged, what will be

American Exploration’s WACC under the revised target capital structure? c. Do you think shareholders are affected by the increase in debt to 70%? If so,

how are they affected? Are their common stock claims riskier now? d. Suppose that in response to the increase in debt, American Exploration’s share-

holders increase their required return so that cost of common equity is 16%. What will its new WACC be in this case?

e. What does your answer in part b suggest about the tradeoff between financing

with debt versus equity?

LG 1 P9–21 ETHICS PROBLEM During the 1990s, General Electric put together a long string of consecutive quarters in which the firm managed to meet or beat the earnings fore-

casts of Wall Street stock analysts. Some skeptics wondered if GE “managed” earn- ings to meet Wall Street’s expectations, meaning that GE used accounting gimmicks to conceal the true volatility in its business. How do you think GE’s long run of meeting or beating earnings forecasts affected its cost of capital? If investors learn that GE’s performance was achieved largely through accounting gimmicks, how do you think they would respond?

Spreadsheet Exercise

Nova Corporation is interested in measuring the cost of each specific type of capital as well as the weighted average cost of capital. Historically, the firm has raised capital

PART 4

Risk and the Required Rate of Return

Source of capital

Weight

Long-term debt

Preferred stock

Common stock equity

The tax rate of the firm is currently 40%. The needed financial information and data are as follows:

Debt Nova can raise debt by selling $1,000-par-value, 6.5% coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of $20 per bond needs to be given. There is an associ- ated flotation cost of 2% of par value.

Preferred stock Preferred stock can be sold under the following terms: The security has a par value of $100 per share, the annual dividend rate is 6% of the par value, and the flotation cost is expected to be $4 per share. The preferred stock is expected to sell for $102 before cost considerations.

Common stock The current price of Nova’s common stock is $35 per share. The cash dividend is expected to be $3.25 per share next year. The firm’s divi- dends have grown at an annual rate of 5%, and it is expected that the dividend will continue at this rate for the foreseeable future. The flotation costs are expected to be approximately $2 per share. Nova can sell new common stock under these terms.

Retained earnings The firm expects to have available $100,000 of retained earnings in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. ( Note: When measuring this cost, the firm does not concern itself with the tax bracket or brokerage fees of owners.)