Chapter 11, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 11 CALCULATING THE COST OF CAPITAL

Questions
LG1

11-1

How would you handle calculating the cost of capital if a firm were planning two
issue two different classes of common stock?

Solution:

As the two different classes of common stock are likely to have different component
costs, calculate the cost and weight for each separately.

LG2

Why dont we multiply the cost of preferred stock by 1 minus the tax rate, as we do
for debt?

11-2

Solution:

Because dividends on preferred stock, unlike interest on debt, are paid out of aftertax income.

LG2

Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the
WACC?

11-3

Solution:

The theoretical minimum WACC would be that for an all-debt firm: iD (1-TC)

LG3

Under what situations would you want to use the CAPM approach for estimating the
component cost of equity? The Constant-Growth model?

11-4

Solution:

You would want to use the CAPM when you can estimate the firms beta with a good
deal of certainty: you would only want to use the constant-growth model if the firms
stock is expected to experience constant dividend growth.

LG3

Could you calculate the component cost of equity for a stock with nonconstant
expected growth rate in dividends if you didnt have the information necessary to
compute the component cost using the CAPM? Why or why not?

11-5

Solution:

You could try and adjust the constant growth model for initial periods of
nonconstant growth, but doing so would require estimating the growth rate for all of
the nonconstant growth periods.

LG4

Why do we use market-based weights instead of book-value-based weights when

computing the WACC?

11-6

Solution:

Because were interested in determining what the cost of financing the firms assets
would be given todays market situation and the component costs the firm currently
faces, not what the historic prices would have been.

LG5

Suppose your firm wanted to expand into a new line of business quickly, and that
management anticipated that the new line of business would constitute over 80

11-7

11-1

Chapter 11, Solutions

Cornett, Adair, and Nofsinger

percent of your firms operations within 3 years. If the expansion was going to be
financed partially with debt, would it still make sense to use the firms existing cost
of debt, or should you compute a new rate of return for debt based on the new line of
business?
Solution:

Given that the new line of business will comprise so much of the firms operations, it
probably isnt appropriate to count on the current, existing operations to pay off the
debt. Therefore, the fir should probably compute a new required rate of return for
this firms debt.

LG6

Explain why the divisional cost of capital approach may cause problems if new
projects are assigned to the wrong division.

11-8

Solution:

If projects are assigned to the wrong division, the risk of that division may be
significantly different than the risk of the project, implying that the project will be
evaluated with a divisional cost of capital that is much different from what a projectspecific cost of capital would be.

LG7

When will the subjective approach to forming divisional WACCs be better than
using the firm-wide WACC to evaluate all projects?

11-9

Solution:

LG8

As long as the subjective approaches manages to use divisional costs of capital that
are, on average, closer to what the project-specific costs of capital would be than
the firm-wide cost of capital is, the subjective approach will improve the firms
accept/reject decisions.

11-10 Suppose a new project was going to be financed partially with retained earnings.
What flotation costs should you use for retained earnings?

Solution:

Retained earnings do not carry any flotation cost, so you should use a cost of zero.

11-2