SOLUTIONS TO END-OF-CHAPTER PROBLEMS

9-1

40% Debt; 60% Equity; kd = 9%; T = 40%; WACC = 9.96%; ks = ? WACC 0.0996 0.0996 0.078 ks = = = = = (wd)(kd)(1 - T) + (wc)(ks) (0.4)(0.09)(1 - 0.4) + (0.6)ks 0.0216 + 0.6ks 0.6ks 13%.

9-2

Pp = $47.50; Dp = $3.80; kp = ? kp = kp =

Dp Pp
$3.80 = 8%. $47.50

9-3

P0 = $30; D1 = $3.00; g = 5%; F = 10%; ks = ?; ke = ? ks =

D1 P 0

+ g =

$3.00 + 0.05 = 15%. $30.00

=

ke =

D1 + g P0(1 F)
=

$3.00 + 0.05 $30(1 - 0.10)

$3.00 + 0.05 = 16.11%. $27.00

9-4

Projects A, B, C, D, and E would be accepted since each projects return is greater than the firms WACC. kd(1 - T) = 0.12(0.65) = 7.80%.

9-5

9-6

kp =

$100(0.11) $11 = = 11.94%. $92.15 $92.15

Answers and Solutions: 9 - 1

9-7

a. ks = ks =

D1 P 0

+ g

$3.18 + 0.06 $36 ks = 14.83%.

b. F = ($36.00 - $32.40)/$36.00 = $3.60/$36.00 = 10%. c. ke = D1/[P0(1 - F)] + g = $3.18/$32.40 + 6% = 9.81% + 6% = 15.81%. 9-8 Capital Sources Long-term debt Equity Amount $1,152 1,728 $2,880 Capital Structure Weight 40.0% 60.0 100.0%

WACC = wdkd(1 - T) + wcks = 0.4(0.13)(0.6) + 0.6(0.16) = 0.0312 + 0.0960 = 12.72%. 9-9 ks = D1/P0 + g = $2(1.07)/$24.75 + 7% = 8.65% + 7% = 15.65%. WACC = wd(kd)(1 - T) + wc(ks); wc = 1 - wd. 13.95% 0.1395 -0.017 wd 9-10 = = = = wd(11%)(1 - 0.35) + (1 - wd)(15.65%) 0.0715wd + 0.1565 - 0.1565wd -0.085wd 0.20 = 20%.

a. kd = 10%, kd(1 - T) = 10%(0.6) = 6%. D/A = 45%; D0 = $2; g = 4%; P0 = $20; T = 40%. Project A: Project B: Rate of return = 13%. Rate of return = 10%.

ks = $2(1.04)/$20 + 4% = 14.40%. b. WACC = 0.45(6%) + 0.55(14.40%) = 10.62%. c. Since the firms WACC is 10.62% and each of the projects is equally risky and as risky as the firms other assets, MEC should accept Project A. Its rate of return is greater than the firms WACC. Project B should not be accepted, since its rate of return is less than MECs WACC. 9-11 Debt = 40%, Equity = 60%. P0 = $22.50, D0 = $2.00, D1 = $2.00(1.07) = $2.14, g = 7%.

Answers and Solutions: 9 - 2

ks =

D1 P 0

+ g =

$2.14 + 7% = 16.51%. $22.50

WACC = (0.4)(0.12)(1 - 0.4) + (0.6)(0.1651) = 0.0288 + 0.0991 = 12.79%. 9-12 If the firm's dividend yield is 5% and its stock price is $46.75, the next expected annual dividend can be computed. Dividend yield = D1/P0 5% = D1/$46.75 D1 = $2.3375. Next, the firm's cost of new common stock can be determined from the DCF approach for the cost of equity. ke = D1/[P0(1 - F)] + g ke = $2.3375/[$46.75(1 - 0.05)] + 0.12 ke = 17.26%. 9-13 a. Examining the DCF approach to the cost of retained earnings, the expected growth rate can be determined from the cost of common equity, price, and expected dividend. However, first, this problem requires that the formula for WACC be used to determine the cost of common equity. WACC 13.0% 10.6% ks = = = = wd(kd)(1 - T) + wc(ks) 0.4(10%)(1 - 0.4) + 0.6(ks) 0.6ks 0.17667 or 17.67%.

From the cost of common equity, the expected growth rate can now be determined. ks = D1/P0 + g 0.17667 = $3/$35 + g g = 0.090952 or 9.10%. b. From the formula for the long-run growth rate: g = (1 - Div. payout ratio) ROE = (1 - Div. payout ratio) (NI/Equity) 0.090952 = (1 - Div. payout ratio) ($1,100 million/$6,000 million) 0.090952 = (1 Div. payout ratio) 0.1833333 0.496104 = (1 Div. payout ratio) Div. payout ratio = 0.503896 or 50.39%. 9-14 If the investment requires $5.9 million, that means that it requires $3.54 million (60%) of equity capital and $2.36 million (40%) of debt capital. In this scenario, the firm would exhaust its $2 million of

Answers and Solutions: 9 - 3

retained earnings and be forced to raise new stock at a cost of 15%. Needing $2.36 million in debt capital, the firm could get by raising debt at only 10%. Therefore, its weighted average cost of capital is: WACC = 0.4(10%)(1 - 0.4) + 0.6(15%) = 11.4%. 9-15 a. If all project decisions are independent, the firm should accept all projects whose returns exceed their risk-adjusted costs of capital. The appropriate costs of capital are summarized below: Project A B C D E F G H Required Investment $4 million $5 million $3 million $2 million $6 million $5 million $6 million $3 million Rate of Return 14.0% 11.5 9.5 9.0 12.5 12.5 7.0 11.5 Cost of Capital 12% 12 8 10 12 10 8 8

Therefore, Ziege should accept projects A, C, E, F, and H. b. With only $13 million to invest in its capital budget, Ziege must choose the best combination of Projects A, C, E, F, and H. Collectively, the projects would account for an investment of $21 million, so naturally not all these projects may be accepted. Looking at the excess return created by the projects (rate of return minus the cost of capital), we see that the excess returns for Projects A, C, E, F, and H are 2%, 1.5%, 0.5%, 2.5%, and 3.5%. The firm should accept the projects which provide the greatest excess returns. By that rationale, the first project to be eliminated from consideration is Project E. This brings the total investment required down to $15 million, therefore one more project must be eliminated. The next lowest excess return is Project C. Therefore, Ziege's optimal capital budget consists of Projects A, F, and H, and it amounts to $12 million. c. Since Projects A, F, and H are already accepted projects, we must adjust the costs of capital for the other two value producing projects (C and E). Project C E Required Investment $3 million $6 million Rate of Return 9.5% 12.5 Cost of Capital 8% + 1% = 9% 12% + 1% = 13%

If new capital must be issued, Project E ceases to be an acceptable project. On the other hand, Project C's expected rate of return still exceeds the risk-adjusted cost of capital even after raising additional capital. Hence, Ziege's new capital budget should consist of Projects A, C, F, and H and requires $15 million of capital.

Answers and Solutions: 9 - 4

9-16

a. ks =

D1 P 0

+ g =

$2.14 + 7% = 9.3% + 7% = 16.3%. $23

b. ks = kRF + (kM - kRF)b = 9% + (13% - 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%. c. ks = Bond rate + Risk premium = 12% + 4% = 16%. d. The bond-yield-plus-risk-premium approach and the CAPM method both resulted in lower cost of common stock estimates than the DCF method. Since financial analysts tend to give the most weight to the DCF method, the firms cost of common equity should be estimated to be about 16.3 percent. 9-17 a. With a financial calculator, input N = 5, PV = -4.42, 6.50, and then solve for I = 8.02% 8%. b. D1 = D0(1 + g) = $2.60(1.08) = $2.81. c. ks = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%. PMT = 0, FV =

9-18

a.

ks 0.09 =

D1 P 0

+ g

$3.60 + g $60.00 0.09 = 0.06 + g g = 3%.

b. Current EPS Less: Dividends per share Retained earnings per share Rate of return Increase in EPS Plus: Current EPS Next years EPS $5.400 3.600 $1.800 0.090 $0.162 5.400 $5.562

Alternatively, EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562. 9-19 a. After-tax cost of new debt: Cost of common equity: Calculate g as follows: With a financial calculator, input N = 9, PV = -3.90, PMT = 0, FV = 7.80, and then solve for I = 8.01% 8%. kd(1 - T) = 0.09(1 - 0.4) = 5.4%.

Answers and Solutions: 9 - 5

ks = 14.6%.

D1 P 0

+ g =

(0.55)($7.80) $4.29 + 0.08 = + 0.08 = 0.146 = $65.00 $65.00

After-tax Weighted Cost = Cost 5.4% 2.16% 14.6% 8.76% WACC = 10.92%

b. WACC calculation: Component Debt[0.09(1 - T)] Common equity (RE) Weight 0.40 0.60

9-20

a. kd(1 - T) = 0.10(1 - 0.3) = 7%. kp = $5/$49 = 10.2%. ks = $3.50/$36 + 6% = 15.72%. b. WACC: Component Debt[0.10(1 - T)] Preferred stock Common stock Weight 0.15 0.10 0.75 After-tax Cost 7.00% 10.20% 15.72% Weighted Cost 1.05% 1.02% 11.79% WACC = 13.86% =

c. Projects 1 and 2 will be accepted since their rates of return exceed the WACC.

Answers and Solutions: 9 - 6