Principles of managerial finance gitman 12th edition solutions manual. Principles of managerial finance. Principles of managerial finance,. Principles of managerial finance gitman 11th edition solutions. Solution manual management finance gitman 13 edition. 12. 12 gitman/zutter principles of managerial finance. Solution manual for principles of managerial finance brief 6th edition by gitman. 2. chapter 1 the role of managerial finance. Principles of managerial finance. Solutions manual principles of managerial finance 14th edition gitman test bank principles of managerial finance 14th. 4. 4 gitman/zutter principles of managerial finance. View larger cover. principles of managerial finance. Gitman managerial finance 11th edition solution manual. View larger cover. principles of managerial finance. 3. chapter 1 the role of managerial finance. Managerial with finance help homework. Gitman managerial finance solutions manual 12th edition. Practice test bank for principles of managerial finance by gitman 12th edition. Principles of managerial finance 12th edition by lawrence j. gitman. solution manual. Principles of managerial finance brief 7th edition solutions manual working capital credit finance . Managerial finance 14th edition gitman 7. Principles of managerial finance gitman zutter 13th edition solutions manual. The requested URL was not found on this server. Additionally, a 404 Not Found error was encountered while trying to use an ErrorDocument to handle the request. Apache/2.4.41 (Ubuntu) Server at gallery.star-board.com Port 443 Principles of Managerial Finance 14th Edition SOLUTIONS MANUAL by Gitman Zutter Completed download Solutions, answer key... Solutions Manual Principles of Managerial Finance 14th Edition Gitman Zutter Principles of Managerial Finance 14th Edition SOLUTIONS MANUAL by Gitman Zutter Completed download Solutions, answer keys, Instructor Manual, Instructor s Resource Manual, Excel solutions solutions are included: included: ’ ’ https://testbankarea.com/download/principles-m https://testbankarea.com/dow nload/principles-managerial-finance-1 anagerial-finance-14th-edition-so 4th-edition-solutionslutionsmanual-gitman-zutter/ Principles of Managerial Finance 14th Edition TEST BANK by Lawrence J. Gitman, Chad J. Zutter. Completed download: https://testbankarea.com/download/principles-m https://testbankarea.com/dow nload/principles-managerial-finance-1 anagerial-finance-14th-edition-tes 4th-edition-test-bankt-bankgitman-zutter/ Chapter 9 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. These T hese individual costs are then combined into a weighted average cost of capital. Students are encouraged to devote time and effort to learning Chapter 9 ’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. Suggested Answers to Opener-in-Review Questions Questions In the chapter opener you learned that Alcoa’ Alcoa ’s weighted average cost of capital was around 12 percent, but its investments were earning returns closer to 5 percent. From 2010 to 2012, Alcoa invested roughly $1 billion in capital expenditures. Suppose Alcoa spends $1 billion expanding its manufacturing facilities today, and that investment produces a net cash flow of $50 million (5 percent of $1 billion) every year in perpetuity. Calculate the NPV of that investment using a 12 percent d iscount rate. How much value does the $1 billion investment create or destroy? Does it seem that Alcoa should be pursuing growth in this market? NPV = CF ÷ r Hence, NPV of the investment = $50 million ÷ 12% = $416.67 million Chapter 9 The Cost of Capital 179 Answers to Review Questions 1. The cost of capital represents represents the firm’s cost of financing in percentage terms. A firm ’s cost of capital is the expected average future cost of funds over the long run. It is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. In order to make any such financing decision, the overall cost of capital must 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. 2. The cost of capital capital provides a benchmark against against which the potential potential rate of return return on an investment investment is compared. Financial managers should only invest in projects that are expected to provide a rate of return in excess of the cost of capital. Selection of projects with returns in excess of the cost of capital increases firm value. The selection of all projects with expected returns re turns that are equal or greater to the firm ’s cost of capital maximizes shareholder wealth. Capital budgeting is the process of evaluating and selecting long-term investments that exceed the cost of capital and thereby maximize shareholder wealth. 3. Capital structure consists of long-term sources of financing, coming from bondholders and stockholders. The cost of each source of financing is weighted by the proportion of long-term funds that come from that source of financing. The long-run average amount of financing from each of these sources represents the target capital structure. When the cost of each source of financing is multiplied by the proportionate amount in the capital structure, the aggregate is the firm ’s weighted average cost of capital. Ultimately, it is the marginal, or incremental, cost of capital necessary to raise the next marginal dollar of financing that is relevant for making investment decisions. 4. The four basic long-term long-term sources of of capital available to firms are long-term long-term debt, preferred stock, stock, common stock, and retained earnings. Common stock refers to the amount obtained by the firm through the issuance of shares, either in an initial public offering or subsequent stock sale. 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. 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 sells at a discount when the rate of interest currently currently paid on similarrisk 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 interest on similar-risk bonds. bonds. Flotation costs costs are fees charged by investment banking firms for their services in assisting in selling the bonds in the primary market. These These costs reduce the total proceeds proceeds received by the firm because the fees are paid from the bond funds. 6. The three approaches approaches to finding the the before-tax cost of debt are the following: following: a. b. c. The quotation approach that uses the current market value of a bond to determine the yield-to-maturity yield-to-maturity on the bond. If the market price of the bond is equal to its par value the yield-to-maturity is the same as the coupon rate. The calculation approach finds the before-tax cost of debt by calculating the internal rate of return (IRR) of the bond’s cash flows. The approximation approach uses the following formula to approximate the before-tax cost of the debt. 180 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition I r d [($1, 0 00 00 N d )] n ( N d $1, 00 000) 2 where: I the annual interest payment in dollars 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. N d d 7. The before-tax cost is converted to an after-tax debt cost cost (r i) by using the following equation: ), where T is is the firm ’s tax rate. r i r d d (1 T ), 8. Answers will vary for question question because because values are are algorithmically algorithmically generated in MyFinanceLab. MyFinanceLab. 9. The cost of preferred stock is found by dividing dividing the annual preferred preferred stock dividend dividend by the net net proceeds from the sale of the preferred stock. The formula is: r p D p N p where: D p the annual dividend payment in dollars N p the net proceeds from the sale of the preferred stock 10. The assumptions underlying the constant-growth constant-growth valuation (Gordon) model are a. b. c. The value of a share of stock is the PV of of all dividends expected to be paid over its life. The rate of growth of dividends dividends and earnings is constant, which means that the firm has a fixed payout payout ratio. Firms perceived by investors investors to be be equally risky have have their expected expected earnings discounted at the same same rate. 11. The CAPM CAPM technique technique directly considers a firm firm ’s risk, through the inclusion of “ beta,” in determining the required rate of return on common stockholders. By contrast, the constant-growth model uses the market price in the denominator. This This price is an indication indication of the expectations of investors investors in the marketplace regarding risk and return. 12. The cost of retained retained earnings is technically less less than the cost cost of new common common stock because by using retained earnings (cash) the firm avoids underwriting costs, as well a s possible underpricing costs. 13. The weighted average cost of capital (WACC ), ), r a, 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. The weights must be nonnegative and sum to 1.0. 14. The weighted average cost of capital (WACC ), ), r a, is highly dependent upon the firm ’s target capital structure. As the proportion of financing arising from a specific source rises, the importance of the cost of that source of financing rises also. Initially projects are funded with retained earnings, which is cheaper because it does not include a floatation cost. However, as the amount of funding from common stockholders rises, the firm is more likely to require external financing. The common c ommon stockholders ’ portion of the weighted average cost of capital will either come from retained earnings or external financing, not both. Chapter 9 The Cost of Capital 181 15. Using target capital structure weights , a 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 significant changes are implied implied by the target capital structure weights, little difference in the weighted marginal cost of capital results from their use. Suggested Answer to Focus on E thics Box: The Ethics of Profit The Vioxx recall increased Merck’s cost of capital. What effect would an increased increased cost of capital have on a firm’s future investments? For an investment to be worthwhile for a firm, the expected return must be greater than the cost of capital. When a firm’s cost of capital increases, it has the potential to make investment oppor tunities that once appeared attractive to the firm suddenly unattractive. Suggested Answer to Focus on P ract ractice ice Box: Uncertain Times Make for an Uncertain Weighted Average Cost of Capital Why don’ don’t firms generally use both short- and long-run weighted average costs of capital? Firms maximize shareholder wealth through investment in fixed assets. Capital budgeting is the process of evaluating and selecting these assets, which are utilized for more than a year. Mismatching of asset life and financing duration increases financial risk. Short-term borrowing is frequently cheaper than long-term sources of funding because the short-term lender knows that the long-term sources of capital ca pital back up the loan. This box reports that Caraustar uses both a short-term and long-term cost of capital, which rises with the length of the debt used in estimating the cost of capital. From an operational standpoint, this would be difficult because short-term rates are quite volatile. Hence, projects that are unacceptable one month might be acceptable the next. The financial manager would have to update a nd disseminate information on the current short-term cost of capital. Another reason most companies do not operate with a short-term and long-term cost of capital is that debt is only a fraction (and in many companies a small fraction) of the financing. Also, to be accurate, one would have to consider the fact that stockholders would increase their required rate of return if they were aware that the debt being used was short-term short-term because loan expiration occurs more more quickly, short-term interest rates are are more volatile and could be higher, and the company may find it difficult to find a lender. Hence, the advantage of using shortterm debt in a WACC may not be as dramatic as observed by Mr. Domanico. One should consider financial financial interrelationships over the long run. Answers to Warm-Up Exercises E9-1. Weighted average cost of capital Answer: N 10, PV $20,000 (1 0.02) $19,600, PMT 0.08 $20,000 $1,600, FV $20,000 Solve for I 8.30% E9-2. Cost of preferred stock Answer: The cost of of preferred stock is the ratio ratio of the preferred stock dividend to the firm ’s net proceeds from the sale of the preferred stock. r p D p N p r p (0.15 $35) ($35 $3) 182 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition r p $5.25 $32 16.4% E9-3. Cost of common stock equity Answer: The cost of common common stock equity can be found by dividing the dividend dividend expected at the end of year year 1 by the current price of the stock and adding the expected growth growth rate. r s ( D D1 P 0) g r s ($6.50 $78) 7% 15.33% E9-4. Weighted average cost of capital Answer: r a (0.35 0.08) (0.65 0.13) 0.0280 0.0845 11.25% E9-5. Weighted average cost of capital Answer: r a (0.55 0.067) (0.10 0.092) (0.35 0.106) 0.0832 8.32% Solutions to Problems P9-1. Concept of cost of capital LG 1; Basic a. b. c. d. e. f. P9-2. Project North is expected to earn an 8% return. If the analyst analyst expects the cost of debt to be 7%, he will probably recommend the project be accepted because expected return is greater than the cost of debt. Project South is expected to earn 15%, but if the analyst believes believes that it will be financed financed with equity that costs 16%, the analyst will likely recommend that the firm reject the project because the expected return (15%) is less than the cost of debt (16%). These decisions may not be in the best interest of a firm firm ’s investors because the firm uses a blend of debt and equity to finance its investments, so the proper “hurdle rate” for investment opportunities ought to reflect the cost of the blend, not the cost of debt or equity alone. The weighted average cost is (0.4 × 7%) + (0.6 × 16%) = 12.4%. If both analysts used 12.4% 12.4% as the hurdle hurdle rate for the investments, then North North would would be rejected, and South would be accepted. When the analysts focus on on a single source of of financing financing rather than the blend blend that the firm actually uses, then they make exactly the wrong recommendations, accepting North when it should be rejected, and rejecting South when it should be accepted. Cost of debt using both methods LG 3; Intermediate a. Net proceeds: N d d $1,010 $30 N d d $980 b. Cash flows: T 0 1 – 15 15 15 CF $ 980 120 1,000 Chapter 9 c. The Cost of Capital 183 Cost to maturity: N 15, PV 980, PMT 120, FV 1,000 Solve for I: 12.30% After-tax cost: 12.30% (1 0.4) 7.38% Approximate before-tax cost of debt d. ($1,000 ($1,000 $98 $980) 0) 15 r d ($980 ($980 $1,000) $1,000) 2 r d d $121.33 $990 r d d 12.26% $120 Approximate after-tax cost of debt 12.26% (1 0.4) 7.36% e. P9-3. The advantages advantages of the the calculator calculator method are evident. evident. There are fewer keypunching keypunching strokes, and one gets the actual cost of debt financing. However, the approximation formula is fairly accurate and expedient in the absence of a financial calculator. Before-tax cost of debt and after-tax cost of debt LG 3; Easy a. N 10, PV 930 (an expenditure), PMT 0.6(1,000) 60, FV 1,000 Solving for I 7.00% b. Use the model: After-tax cost of of debt before-tax cost of debt (1 tax bracket) 7.0% (1 0.2) 5.6% P9-4. Cost of debt using the approximation formula: LG 3; Basic $1,000 N d I r d n N d $1,000 r i r d d (1 T ) 2 Bond A $90 r d $1,000 $1,000 $955 $955 20 $955 $955 $1,000 $1,000 $92.25 $977.50 9.44% 2 r i 9.44% (1 0.40) 5.66% Bond B $1,000 $1,000 $970 $970 $101.88 16 10.34% $970 $970 $1,000 $1,000 $985 2 $100 r d r i 10.34% (1 0.40) 6.20% 184 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition Bond C $120 r d $1,000 $1,000 $955 $955 15 $955 $955 $1,000 $1,000 $123 $977.50 12.58% 2 r i 12.58% (1 0.40) 7.55% Bond D $90 r d $1,000 $1,000 $985 $985 25 $985 $985 $1,000 $1,000 $90.60 $992.50 9.13% 2 r i 9.13% (1 0.40) 5.48% Bond E $1,000 $1,000 $920 $920 $113.64 22 $920 $920 $1,000 $1,000 $960 2 $110 r d 11.84% r i 11.84% (1 0.40) 7.10% P9-5. Cost of debt using the approximation formula LG 3; Intermediate I r d $1,000 N d n N d $1,000 r i r d (1 T ) 2 Alternative A $90 r d $1,000 $1,000 $1,220 $1,220 16 $1,220 $1,220 $1,000 $1,000 $76.25 $1,110 6.87% 2 r i 6.87% (1 0.40) 4.12% Calculator: N 16, PV $1,220, PMT $90, FV $1,000 Solve for I: 6.71% After-tax cost of debt: 4.03% Chapter 9 The Cost of Capital 185 Alternative B $70 r d $1,000 $1,000 $1, $1, 020 5 $1,020 $1,020 $1,000 $1,000 $66.00 $1,010 6.53% 2 r i 6.53% (1 0.40) 3.92% Calculator: N 5, PV $1,020, PMT $70, FV $1,000 Solve for I: 6.52% After-tax cost of debt: 3.91% Alternative C $60 r d $1,000 $1,000 $970 $970 7 $970 $970 $1,000 $1,000 $64.29 $985 6.53% 2 r i 6.53% (1 0.40) 3.92% Calculator: N 7, PV $970, PMT $60, FV $1,000 Solve for I: 6.55% After-tax cost of debt: 3.93% Alternative D $1,000 $1,000 $895 $895 10 $895 $89 5 $1,000 $1,000 2 $50 r d $60.50 $947.50 6.39% r i 6.39% (1 0.40) 3.83% Calculator: N 10, PV $895, PMT $50, FV $1,000 Solve for I: 6.46% After-tax cost of debt: 3.87% P9-6. After-tax cost of debt LG 3; Intermediate a. The after-tax cost cost of borrowing borrowing from the motorcycle dealer is the same as the pretax cost, 5%. b. The after-tax cost of taking out out the second mortgage is 6% × (1 – 25%) 25%) = 4.5%. c. The mortgage mortgage loan would cost cost less after taxes compared to the loan from the dealer. d. If Bella takes out a loan loan on her home that she cannot repay, she may risk losing her home. If If she cannot repay the motorcycle loan, the lender may not have a claim against Bella ’s home and may only be able to retake possession of the motorcycle. 186 P9-7. P9-8. Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition Cost of preferred stock: r p D p N p LG 2; Basic a. r p b. r p $12.00 $95.00 $10.00 $90.00 12.63% 11.11% Cost of preferred stock: r p D p N p LG 4; Basic Preferred Stock A B C D E P9-9. Calculation r p r p r p r p r p $11.00 3.20 5.00 3.00 1.80 $92.00 34.50 33.00 24.50 17.50 11.96% 9.28% 15.15% 12.24% 10.29% Cost of common stock equity — capital capital asset pricing model (CAPM) LG 5; Intermediate )] r s R F [b (r m R F )] r s 6% 1.2 (11% 6%) r s 6% 6% r s 12% a. Risk premium 6% b. c. Rate of return 12% After-tax cost of common equity using the CAPM 12% P9-10. P9-10. Cost of common stock equity: k n D1 g N n LG 5; Intermediate a. N 4 (2015 2011), PV (initial value) Solve for I (growth rate): 9.97% b. N n $52 (given in the problem) c. r r r (Next Dividend Current Price) growth rate r r r ($3.40 $57.50) 0.0997 r r r 0.0591 0.0997 0.1588 or 15.88% d. $2.12, FV (terminal value) $3.10 r r r ($3.40 $52) 0.0997 r r r 0.0654 0.0997 0.1651 or 16.51% Chapter 9 The Cost of Capital 187 P9-11. P9-11. Retained Retaine d earnings versus new common stock LG 5; Intermediate rr D1 P 0 g rn D1 N n g Firm Calculation A r r r ($2.25 $50.00) 8% 12.50% r n ($2.25 $47.00) 8% 12.79% B r r r ($1.00 $20.00) 4% 9.00% r n ($1.00 $18.00) 4% 9.56% C r r r ($2.00 $42.50) 6% 10.71% r n ($2.00 $39.50) 6% 11.06% D r r r ($2.10 $19.00) 2% 13.05% r n ($2.10 $16.00) 2% 15.13% P9-12. P9-12. Effect of tax rate on WACC LG 3, 4, 5, 6; Intermediate a. WACC (0.40)(6%)(1 0.40) (0.10)(8%) (0.50)(10%) WACC 1.44% 0.8% 5% WACC 7.24% b. WACC (0.40)(6%)(1 0.35) (0.10)(8%) (0.50)(10%) WACC 1.56% 0.8% 5% WACC 7.36% c. WACC (0.40)(6%)(1 0.25) (0.10)(8%) (0.50)(10%) WACC 1.80% 0.8% 5% WACC 7.60% d. P9-13. As the tax rate falls, the weighted-average weighted-average cost of of capital goes up. The lower lower the tax rate, the lower the government “subsidy” for debt. WACC — book weights LG 6; Basic a. Type of Capital Long-term debt Preferred stock Common stock b. Book Value $700,000 50,000 650,000 $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% The WACC is the rate of return that the firm must receive on long-term projects projects to maintain the value value of the firm. The cost of capital can be compared to the return for a project to determine whether the project is acceptable. 188 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition P9-14. WACC — book weights and market weights LG 6; Intermediate a. Book value weights: Type of Capital Book Value Long-term debt Preferred stock Common stock b. $4,000,000 40,000 1,060,000 $5,100,000 Cost 0.784 0.008 0.208 6.00% 13.00% 17.00% Weight Cost 0.557 0.009 0.435 6.00% 13.00% 17.00% Weighted Cost 4.704% 0.104% 3.536% 8.344% Market value weights: Type of Capital Market Value Long-term debt Preferred stock Common stock c. Weight $3,840,000 60,000 3,000,000 $6,900,000 Weighted Cost 3.342% 0.117% 7.395% 10.854% The difference difference lies in the the two different value bases. bases. The market value value approach yields the better better value because the costs of the components components of the capital structure structure are calculated using the the prevailing market prices. Because the common stock is selling selling at a higher value value than its book value, the cost 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. P9-15. P9-15. WACC and target weights LG 6; Intermediate a. b. c. Historical market weights: Type of Capital Weight Cost Long-term debt Preferred stock Common stock 0.25 0.10 0.65 7.20% 13.50% 16.00% Type of Capital Weight Cost Long-term debt Preferred stock Common stock 0.30 0.15 0.55 7.20% 13.50% 16.00% Weighted Cost 1.80% 1.35% 10.40% 13.55% Target market weights: Weighted Cost 2.160% 2.025% 8.800% 12.985% Using the historical weights, the firm has a higher cost 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 expensive long-term debt and the lower-costing preferred stock. Chapter 9 P9-16. P9-16. Cost of capital LG 3, 4, 5, 6; Challenge a. Cost of retained earnings r $1.26(1 0.06) r b. 0.06 $40.00 3.35% 6% 9.35% $1.26(1 0.06) $40.00 $7.00 0.06 $1.34 $33.00 4.06% 6% 10.06% Cost of preferred stock $2.00 r p $25. $25.00 00 $100 d. $1.34 Cost of new common stock r s c. $40.00 r d $2.00 $3.0 $3.00 0 $22. $22.00 00 9.09% $1,000 $1,000 $1,175 $1,175 5 $1,175 $1,175 $1,000 $1,000 $65.00 $1,087.50 5.98% 2 r i 5.98% (1 0.40) 3.59% e. WACC (0.40)(3.59%) (0.10)(9.09%) (0.50)(9.35%) WACC 1.436 0.909 4.675 WACC 7.02% P9-17. P9-17. Calculation Calculat ion of individual individua l costs, WACC, and WMCC LG 3, 4, 5, 6; Challenge a. After-tax cost of debt Approximate Approach I r d ($1, 00 000 N d ) n ( N d $1, 00 000) 2 ($1,000 ($1,000 $95 $950) 0) $100 $5 10 10.77% ($950 ($950 $1,000) $1,000) $975 2 $100 r d r i 10.77 (l 0.40) r i 6.46% Calculator approach N 10, PV $950, PMT $100, FV $1,000 Solve for I: 10.84% After-tax cost of debt: 10.84 (1 0.40) 6.51% The Cost of Capital 189 190 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition b. Cost of preferred stock: r p $8 r p c. $63 D p N p 12.70% Cost of new common stock equity: Solve for g: N 4, PV $2.85, FV $3.75 Solve for I: 7.10% Net Proceeds: Current price – Price Price adjustment – Floatation Floatation cost $50 $5 $3 $42 r n $4.00 $42.00 0.0710 0.0952 0.0710 0.1662 $16.62% d. WACC: Long-term debt 0.40 6.51% Preferred stock 0.10 12.70% Common stock 0.50 16.62% WACC 2.60% 1.27% 8.31% 12.18% P9-18. P9-18. Personal finance finance problem: problem: Weighted-average Weighted-average cost of capital LG 6; Intermediate Rate [1] Outstanding Loan Balance [2] Weight [2] 64,000 [3] WACC [1] [3] oan 1 6.00% $ 20,000 31.25% 1.88% oan 2 9.00% $12,000 18.75% 1.69% oan 3 otal 5.00% $32,000 $64,000 50.00% 2.50% 6.06% John Dough should not consolidate his college loans because their weighted cost is less than the 7.2% offered by his bank. P9-19. P9-19. Calculation Calculat ion of individual costs and WACC LG 3, 4, 5, 6; Challenge a. After-tax cost of debt Approximate approach I r d ($1, 00 000 N ) d n ( N d $1, 00 000) 2 ($1,000 ($1,000 $94 $940) 0) $80 $3 20 8.56% ($940 ($940 $1,000) $1,000) $970 2 $80 r d Chapter 9 The Cost of Capital r i rd (1 t ) r i 8.56% (1 0.40) r i 5.14% Calculator approach N 20, PV $940, PMT $80, FV $1,000 Solve for I: 8.64% After-tax cost of debt: 8.64% (1 0.40) 5.18% b. Preferred stock: c. r p r p D p N p $7.60 $90 8.44% Retained earnings: rr D1 P 0 g = ($7.00 ÷ $90) + 0.06 = 0.0778 + 0.0600 = 0.1378 or 13.78% New common stock: rn D1 N n g = [$7.00 ÷ ($90 $7 $5)] + 0.06 = [$7.00 ÷ $78] + 0.06 = 0.0897 + 0.0600 = 0.1497 or 14.97% Type of Capital 2. 3. With retained earnings Long-term debt Preferred stock Common stock equity Target Capital Structure % Cost of Capital Source Weighted Cost 0.30 0.20 0.50 5.18% 1.55% 8.44% 1.69% 13.78% 6.89% WACC 10.13% 0.30 0.20 0.50 5.18% 1.55% 8.44% 1.69% 14.97% 7.48% WACC 10.72% With new common stock Long-term debt Preferred stock Common stock equity P9-20. P9-20. Weighted-average Weighted-a verage cost of capital LG 6; Intermediate a. WACC 0.50 (0.06) 0.50 (0.12) 0.03 0.06 0.09 or 9.0% b. WACC 0.70 (0.06) 0.30 (0.12) 0.042 0.036 0.078 or 7.8% 191 192 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition c. They are affected because, under the revised capital capital structure, structure, there is more debt financing. financing. Bond holders represent a prior, legal claim to the firm ’s operating income. A larger interest expense must be paid prior to any dividend dividend payment. There is also a greater greater chance of bankruptcy because the the firm ’s operating income may be insufficiently large to accommodate the larger interest expense. d. WACC 0.70 (0.06) 0.30 (0.16) 0.042 0.048 0.09, or 9% e. Increasing the percentage of debt financing increases the risk of the company not being able to make its interest payments. Bankruptcy would have negative consequences to both bondholders and stockholders. As shown in part d, if stockholders increase their required rate of return, the cost of capital may not decline. In fact, if the bondholders required a higher return also, the cost of capital would actually rise in this scenario. P9-21. Ethics problem LG 1; Intermediate GE’s long string of good earnings reports made the company seem less risky, so it ’s cost of capital would be lower (e.g., the AAA credit rating mentioned mentioned in the chapter opener opener is evidence of this). If investors investors learn that GE is really more risky than it seems, then the cost of capital will go up, and GE ’s value will fall. Case Case studies are available on www.myfinancelab.com. Making Star Products Financing/Investment Decision ’ The Chapter 9 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 break points associated with each source; and c alculate the WACC. Finally, the student must decide which investments to recommend to Star Products. a. Cost of financing sources Debt: (1) Below $450,000: Calculator Method: N 15, PV $960, PMT $90, FV $1,000 Solve for I 9.51% r i r d d (1 t ) r i 9.51 (1 0.4) r i 5.71% Chapter 9 Approximation Method: I r d ($1, 00 000 N d ) n ( N d $1, 00 000) 2 ($1,000 ($1,000 $96 $960) 0) 15 r d ($960 ($960 $1,000) $1,000) 2 $92.67 0.0946 46 9.46 9.46% % r d 0.09 $980 r i r d d (1 t ) $90 r i 9.46 (1 0.4) r i 5.68% (2) Above $450,000: r i r d d (1 t ) r i 13.0 (1 0.4) r i 7.8% (3) Preferred stock: r p D p r p N p $9.80 $65 0.1508 0.1508 Common stock equity: (4) $0$1,500,000: rr Di P 0 g $0.96 r r $12 0.11 0.11 19% 19% (5) Above $1,500,000: rr r r Di N n g $0.96 $9 0.11 0.11 21.6 21.67% 7% 15.08% 15.08% The Cost of Capital 193 194 b. Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition Weighted average cost of capital: capital: Target Capital Structure % Type of Capital c. Cost of Capital Source Weighted Cost 1. Long-term debt less than $450,001 and common equity less than $500,001: Long-term debt 0.30 5.7% 1.71% Preferred stock 0.10 15.1% 1.51% Common stock equity 0.60 19.0% 11.40% 1.00 WACC 14.62% 2. Long-term debt greater than $450,000 and common equity less than $1,500,00: Long-term debt 0.30 7.8% 2.34% Preferred stock 0.10 15.1% 1.51% Common stock equity 0.60 19.0% 11.40% 1.00 WACC 15.25% 3. Long-term debt greater than $450,000 and common equity more than $1,500,000: Long-term debt 0.30 7.8% 2.34% Preferred stock 0.10 15.1% 1.51% Common stock equity 0.60 21.7% 13.02% 1.00 WACC 16.87% Break points Break point AF W $450,000 (1) BPLong-term debt (2) BPcommon equity 0.30 $1,500,000 $1, 500, 000 $2, 500, 000 0.60 (3) Based on the information above, cheaper debt financing is exhausted when the value of projects accepted exceeds $1,500,000. Retained earnings can finance $2,500,000 of new projects without having having to issue additional additional debt. In the prior calculation calculation of weighted average average costs of capital, a weighted average costs of capital for cheap debt and external equity financing was not needed because Star Products runs out of financing from cheap debt first. Chapter 9 The Cost of Capital 195 d. Investments are ranked in terms of their rate of return. The project with with the highest rate of return return is Project C, which yields 25%. Project G ’s 14% rate of return is the worst. The diagram on the next page depicts the ranking of projects and includes the weighted marginal costs of capital. The jumps in the WMCC occur at break points where a cheaper source of financing financing is exhausted. e. (1) Cheap debt and equity The first break point exists when Star Products has used all $450,000 in 9% debt. Assuming that a more costly source of debt financing is not available, the firm would accept projects C, D, and B. (2) Cheap debt and half as much retained earnings If Star Products only had $750,000 in common stock equity available, its equity break point would be $1,250,000 ($750,000 0.6). This amount is still sufficient to financeProjects C, D, and B, which combined have a cost of $1,300,000. (3) Cheap debt and all $1,500,000 $1,500,000 of retained earnings earnings (illustrated in Part d) If Star Products can acquire $1,500,000 in common equity, it can finance $2,500,000 of new projects. This allows it to add Projects F and E. The return on Projects A and G is not sufficient to allow acceptance of these projects. (4) Limited total debt and $1,500,000 $1,500,000 of retained earnings If Star Products is limited by access to only a $1,000,000 of long-term debt, its break point would be $3,333,333 ($1,000,000 0.3). The one million dollar amount would be sufficient to finance all projects, which in total cost $3,300,000, if their returns were sufficient. As stated above, the returns on project A and G are less than the weighted marginal cost of capital and will be rejected. Spreadsheet Exercise The answer to Chapter 9 ’s measurement of the cost of capital at Nova Corporation spreadsheet problem is located located on the Instructor ’s Resource Center at www.pearsonhighered.com/irc under the Instructor ’s Manual. 196 Gitman/Zutter • Principles of Managerial Finance, Finance, Fourteenth Edition Group Exercise Group exercises are available on www.myfinancelab.com. 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. Finally, the group identifies a new project, identifies its IRR, and compares it to the estimated WACC in order to determine whether the new project should be accepted. One alternative is for the instructor to identify a series of projects and their cash flows, requiring students to determine the acceptability of each given the estimated WACC. Integrative Case 4: Eco Plastics Company This case focuses on determination of the cost c ost of capital for a firm. f irm. The student determines the cost of individual sources of financing, including long-term debt, preferred stock, and common stock. The cost of debt is adjusted for Eco Plastics’ 40% tax bracket. The company is considering a new financial structure, with the r eplacement of preferred stock financing with with debt financing. Additional Additional use of debt increases increases the common stockholders stockholders ’ required rate of return. The student is asked to compare the two weighted average costs of capital and identify the better financial structure for Eco Plastics Company. a. Cost of debt: Proceeds from sale of $1,000 par value bond: $1,000 (average discount & floatation costs) $1,000 ($45 $32) $923 Subsequent payments: Interest payments ($1,000 0.105) Par value Before-tax cost of debt N 20, PV $923, PMT 105, FV 1,000 Solve for I 11.50% After-tax cost of debt: r i r d (1−T ) d (1 11.5% (10.4) 6.9% b. Cost of preferred stock: r p D p N p (0.095 $95) ($95 − $7) $8.55 $88 9.72% c. Cost of common stock: )] r j R F [b j (r m R F )] 0.04 [1.3 (0.13 0.04)] 0.04 [1.3 0.09] 0.04 0.1170 15.7% Chapter 9 d. Weighted average cost of capital: The Cost of Capital 197 r a (wi r i) (w p r p) (w s r n) (0.30 0.069) (0.20 0.0972) (0.50 0.157) 0.0207 0.0194 0.785 0.1186, or about 12% e. 1. Change in risk Premium: Change in beta market risk premium (1.5 1.3) (0.13 0.04) 0.2 0.09 0.018 Shareholders require 1.8% more per year New cost of common equity: equity: r j R F [b j (r m R F )] )] 0.04 [1.5 (0.13 0.04)] 0.04 [1.5 0.09] 0.04 0.1350 17.5% Note: 17.5% 15.7% 1.8% 2. Revised weighted average cost of capital: r a (wi x r i) (w s x r n) (0.50 0.069) (0.50 0.175) 0.0345 0.0875 0.1220 3. Eco Plastics’ CFO should retain the cheaper c heaper current financial structure. Replacing preferred stock financing with debt financing results in more risk r isk to the stockholders. The increase in stockholders ’ required rate of return more than offsets the advantage of using the low cost debt. If Eco Plastics ’ CFO were to revise the capital structure, share price would fall and shareholder wealth would not be maximized. 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