Chapter-Ten

Long-Term Financial Decisions

Solutions to Numerical Questions: Set-II
10-1

LG 1: Concept of Cost of Capital

a.

The firm is basing its decision on the cost to finance a particular project rather
than the firms combined cost of capital. This decision-making method may lead
to erroneous accept/reject decisions.

b.

ka
ka
ka
ka

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.

10-2

LG 2: Cost of Debt Using Both Methods

a.

Net Proceeds:

b.

Cash Flows:

c.

Cost to Maturity:

=
=
=
=

wdkd + weke
.40 (7%) + .60(16%)
2.8% + 9.6%
12.4%

Nd = $1,010 - $30
Nd = $980
t
0
1-15
15

CF
$ 980
-120
-1,000

n
I M
Bo =
+
t
n
t =1 (1 + k ) (1 + k )
15 $120 $1,000
+
$980 =
t
15
t =1 (1 + k ) (1 + k )
Step 1:

Try 12%
V = 120 x (6.811) + 1,000 x (.183)
V = 817.32 + 183

Source: BBA Study Manual-www.cbopublications.com.bd

V = $1,000.32
(Due to rounding of the PVIF, 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 x (6.462) + 1,000 x (.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

Step 4:

$20.32 $64.88

Step 5:
12 + .31
12.31 (1 - .40)

=
=
=

.31
12.31% = before-tax cost of debt
7.39% = after-tax cost of debt

Calculator solution: 12.30%

d.

Approximate before-tax cost of debt

kd =

$1,000 Nd
n
Nd + $1,000
2

I+

($1,000 $980)
15
kd =
($980 + $1,000)
2
kd = $121.33 $990.00
kd = 12.26%
$120 +

Approximate after-tax cost of debt = 12.26% x (1 - .4) = 7.36%

e.

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.

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Chapter 11 Long-Term Financial Decisions

10-3

LG 2: Cost of DebtUsing the Approximation Formula:

kd =

$1,000 Nd
n
Nd + $1,000
2

I+

ki = kd x (1 - T)

Bond A

$1,000 $955
$92.25
20
=
= 9.44%
kd =
$955 + $1,000
$977.50
2
ki = 9.44% x (1 - .40) = 5.66%
$90 +

Bond B

$1,000 $970
$101.88
16
=
= 10.34%
kd =
$970 + $1,000
$985
2
ki = 10.34% x (1 - .40) = 6.20%
$100 +

Bond C

$1,000 $955
$123
15
=
= 12.58%
kd =
$955 + $1,000
$977.50
2
ki = 12.58% x (1 - .40) = 7.55%
$120 +

Bond D

$1,000 $985
$90.60
25
=
= 9.13%
kd =
$985 + $1,000
$992.50
2
ki = 9.13% x (1 - .40) = 5.48%
$90 +

Bond E

$1,000 $920
$113.64
22
=
= 11.84%
kd =
$920 + $1,000
$960
2
ki = 11.84% x (1 - .40) = 7.10%
$110 +

163

Source: BBA Study Manual-www.cbopublications.com.bd

10-4

LG 2: The Cost of Debt Using the Approximation Formula

kd =

$1,000 Nd
n
Nd + $1,000
2

I+

ki = kd x (1 - T)

Alternative A
$1,000 $1,220
$90 +
$76.25
16
=
= 6.87%
kd =
$1,220 + $1,000
$1,110
2
ki = 6.87% x (1 - .40) = 4.12%
Alternative B
$1,000 $1,020
$70 +
$66.00
5
=
= 6.54%
kd =
$1,020 + $1,000
$1,010
2
ki = 6.54% x (1 - .40) = 3.92%
Alternative C
$1,000 $970
$60 +
$64.29
7
=
= 6.53%
kd =
$970 + $1,000
$985
2
ki = 6.53% x (1 - .40) = 3.92%
Alternative D
$1,000 $895
$50 +
$60.50
10
=
= 6.39%
kd =
$895 + $1,000
$947.50
2
ki = 6.39% x (1 - .40) = 3.83%
10-5
a.

b.
11-6

LG 2: Cost of Preferred Stock: kp = Dp Np

$12.00
kp =
= 12.63%
$95.00

$10.00
= 11.11%
$90.00
LG 2: Cost of Preferred Stock: kp = Dp Np
kp =

164

Chapter 11 Long-Term Financial Decisions

10-7

Preferred Stock
Calculation
A
kp = $11.00 $92.00
B
kp =
3.20
34.50
C
kp =
5.00
33.00
D
kp =
3.00
24.50
E
kp =
1.80
17.50
LG 3: Cost of Common Stock EquityCAPM
ks
ks
ks
ks

=
=
=
=

=
=
=
=
=

11.96%
9.28%
15.15%
12.24%
10.29%

RF + [b x (km - RF)]
6% + 1.2 x (11% - 6%)
6% + 6%
12%

a. Risk premium

= 6%

b. Rate of return

= 12%

c. After-tax cost of common equity using the CAPM = 12%

10-8

LG 3: Cost of Common Stock Equity: kn =

a.

g=

D2003
= FVIFk%,4
D1999

g=

$3.10
= 1.462
$2.12

D1 + g
Nn

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)

c.
D 2004
+g
P0
$3.40
kr =
+ .10 = 15.91%
$57.50
kr =

165

Source: BBA Study Manual-www.cbopublications.com.bd

d.
D 2004
+g
Nn
$3.40
kr =
+ .10 = 16.54%
$55.00
kr =

10-9

LG 3: Retained Earnings versus New Common Stock

D1
D1
kr =
kn =
+g
+g
P0
Nn
Firm
A
B
C
D

kr
kn
kr
kn
kr
kn
kr
kn

=
=
=
=
=
=
=
=

Calculation
($2.25 $50.00) + 8%
($2.25 $47.00) + 8%
($1.00 $20.00) + 4%
($1.00 $18.00) + 4%
($2.00 $42.50) + 6%
($2.00 $39.50) + 6%
($2.10 $19.00) + 2%
($2.10 $16.00) + 2%

=
=
=
=
=
=
=
=

12.50%
12.79%
9.00%
9.56%
10.71%
11.06%
13.05%
15.13%

10-10 LG 2, 4: The Effect of Tax Rate on WACC

a.

WACC = (.30)(11%)(1 .40) + (.10)(9%) + (.60)(14%)

WACC = 1.98% + .9% + 8.4%
WACC = 11.28%

b.

WACC = (.30)(11%)(1 .35) + (.10)(9%) + (.60)(14%)

WACC = 2.15% + .9% + 8.4%
WACC = 11.45%

c.

WACC = (.30)(11%)(1 .25) + (.10)(9%) + (.60)(14%)

WACC = 2.48% + .9% + 8.4%
WACC = 11.78%

d.

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

10-11 LG 4: WACCBook Weights

a.

Type of Capital
L-T Debt
Preferred stock
Common stock

Book Value
$ 700,000
50,000
650,000
$1,400,000

Weight
0.500
0.036
0.464
1.000
166

Cost
5.3%
12.0%
16.0%

Weighted Cost
2.650%
.432%
7.424%
10.506%

Chapter 11 Long-Term Financial Decisions

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.

10-12 LG 4: WACCBook Weights and Market Weights

a.

b.

c.

Book value weights:

Type of Capital
Book Value
L-T Debt
$4,000,000
Preferred stock
40,000
Common stock
1,060,000
$5,100,000

Weight
0.784
0.008
0.208

Cost
6.00%
13.00%
17.00%

Weighted Cost
4.704%
.104%
3.536%
8.344%

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

Weight
0.557
0.009
0.435

Cost
6.00%
13.00
17.00

Weighted Cost
3.342%
.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.

10-13 LG 4: WACC and Target Weights

a.

b.

Historical market weights:

Type of Capital
Weight
L-T Debt
.25
Preferred stock
.10
Common stock
.65

Cost
7.20%
13.50%
16.00%

Weighted Cost
1.80%
1.35%
10.40%
13.55%

Target market weights:

Type of Capital
Weight
L-T Debt
.30
Preferred Stock
.15
Common Stock
.55

Cost
7.20%
13.50%
16.00%

Weighted Cost
2.160%
2.025%
8.800%
12.985%

10-14 LG 2, 3, 4, 5: Cost of Capital and Break Point

167

Source: BBA Study Manual-www.cbopublications.com.bd

a.

b.

Cost of Retained Earnings

$1.26(1 + .06)
$1.34
kr =
+ .06 =
= 3.35% + 6% = 9.35%
$40.00
$40.00
Cost of New Common Stock

ks =
c.

Cost of Preferred Stock

kp =
d.

$1.26(1 + .06)
$1.34
+ .06 =
= 3.44% + 6% = 9.44%
$40.00 $1.00
$39.00

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

$1,000 $1,175
$65.00
5
=
= 5.98%
kd =
$1,175 + $1,000
$1,087.50
2
ki = 5.98% x (1 - .40) = 3.59%
$100 +

e.
BPcommon equity =

f.

$4,200,000 - ($1.26 1,000,000) $2,940,000

=
= $5,880,000
.50
.50

WACC = (.40)(3.59%) + (.10)(9.09%) + (.50)(9.35%)

WACC = 1.436 + .909 + 4.675
WACC = 7.02%
This WACC applies to projects with a cumulative cost between 0 and $5,880,000.

g.

WACC = (.40)(3.59%) + (.10)(9.09%) + (.50)(9.44%)

WACC = 1.436 + .909 + 4.72
WACC = 7.07%
This WACC applies to projects with a cumulative cost over $5,880,000.

168

Chapter 11 Long-Term Financial Decisions

10-15 LG 2, 3, 4, 5: Calculation of Specific Costs, WACC, and WMCC

a.

Cost of Debt: (approximate)

($1,000 Nd )
I+
n
kd =
( Nd + $1,000)
2

kd =

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

$100 +

ki = 10.77 x (l - .40)
ki = 6.46%
Cost of Preferred Stock: kp = Dp Np
kp = $8 $63 = 12.70%
Cost of Common Stock Equity: ks = (D1 P0) + g
Growth rate:
$4.00 $2.85 = 1.403
Look for FVIF factor nearest 1.403.
From FVIF table:
g = 7%
Calculator solution: 7.1%
kr = ($4.00 $50.00) + 7% = 15.00%
Cost of New Common Stock Equity:
kn = ($4.00 $42.00) + 7% = 16.52%
b.

Breaking point = AFj Wj

BPcommon equity = [$7,000,000 x (1 - .6)*)] 0.50 = $5,600,000
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.
*

c.

The firm expects to pay 60% of all earnings available to common

shareholders as dividends.

WACC - $0 to $5,600,000:

L-T Debt
169

.40 x

6.46% =

2.58%

Source: BBA Study Manual-www.cbopublications.com.bd

Preferred stock
Common stock

d.

WACC - above $5,600,000:

a.

Debt: (approximate)

.40 x 6.46% = 2.58%

.10 x 12.70% = 1.27%
.50 x 16.52% = 8.26%
WACC
= 12.11%
10-16 LG 2, 3, 4, 5: Calculation of Specific Costs, WACC, and WMCC

kd =

kd =

L-T Debt
Preferred stock
Common stock

.10 x 12.70% = 1.27%

.50 x 15.00% = 7.50%
WACC
= 11.35%

($1,000 Nd )
n
( Nd + $1,000)
2

I+

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

$80 +

ki = kd x (1 - t)
ki = 8.56% x (1 - .40)
ki = 5.1%
Preferred Stock:
Dp
kp =
Np
$7.60
= 8.44%
kp =
$90
Common Stock:
Dj
kn =
+g
Nn
$7.00
kp =
= .06 = .1497 = 14.97%
$78

170

Chapter 11 Long-Term Financial Decisions

Retained Earnings:
D1
kr =
+g
P0
$7.00
kp =
= .06 = .1378 = 13.78%
$90
b.

Breaking point =

(1)

(2)

(3)

BPcommon equity =

AFj
Wi

[$100,000 ] = $200,000
.50

Target Capital
Type of Capital
Structure %
WACC equal to or below $200,000 BP:
Long-term debt
.30
Preferred stock
.20
Common stock equity .50

WACC above $200,000 BP:

Long-term debt
.30
Preferred stock
.20
Common stock equity .50

Cost of
Capital Source
5.1%
8.4%
13.8%
WACC

5.1%
8.4%
15.0%
WACC

Weighted
Cost

1.53%
1.68%
6.90%
10.11%

1.53%
1.68%
7.50%
10.71%

10-17 LG 4, 5, 6: IntegrativeWACC, WMCC, and IOS

a.

Breaking Points and Ranges:

Source
Cost
Range of
Breaking
Range of Total
of Capital
% New Financing
Point
New Financing
Long-term debt
6
$0 - $320,000 $320,000 .40 = $800,000 $0 - $800,000
8
$320,001
Greater than
and above
$800,000
Preferred stock 17
$0 and above
Greater than $0
Common stock 20
$0 - $200,000 $200,000 .40 = $500,000 $0 - $500,000
equity
24
$200,001
Greater than
and above
$500,000
b.
WACC will change at $500,000 and $800,000.

171

Source: BBA Study Manual-www.cbopublications.com.bd

c.

WACC:
Range of Total
New Financing

Source of
Capital
(1)
Debt
Preferred
Common

$0 - $500,000

d.

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

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

IOS Data for Graph

Investment
E
C
G
A
H
I
B
D
F

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

IRR
23%
22
21
19
17
16
15
14
13

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

IOS and WMCC

24

23

22

21
20

19

Weighted Average
Cost of
Capital/Return (%)

18

17

WMCC

16

15

14

13

IOS

12
0

300

600

900

1200

1500

1800

2100

Total New Financing or Investment (000)

172

2400

Chapter 11 Long-Term Financial Decisions

e.

The firm should accept investments E, C, G, A, and H, since for each of these, the
internal rate of return (IRR) on the marginal investment exceeds the weighted marginal
cost of capital (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%.

10-18 LG 4, 5, 6: IntegrativeWACC, WMCC, and IOC

a.

b.

WACC: 0 to $600,000

= (.5)(6.3%) + (.1)(12.5%) + (.4)(15.3%)

= 3.15% + 1.25% + 6.12%
= 10.52%

WACC: $600,001 - $1,000,000

= (.5)(6.3%) + (.1)(12.5%) + (.4)(16.4%)

= 3.15% + 1.25% + 6.56%
= 10.96%

WACC: $1,000,001 and above

= (.5)(7.8%) + (.1)(12.5%) + (.4)(16.4%)

= 3.9% + 1.25% + 6.56%
= 11.71%

See part c for the WMCC schedule.

All four projects are recommended for acceptance since the IRR is greater than the
WMCC across the full range of investment opportunities.

c.
IOS and WMCC
15
H
14

Weighted Average
Cost of Capital/
Return (%)

G
13

WMCC

12
M
A

IOS

11

10
0

200

400

600

800

1000

1200

1400

1600

1800

2000

Total New Financing/Investment ($000)

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.

173