Coleman Technologies Inc.

Cost of Capital 9-22 COLEMAN TECHNOLOGIES IS CONSIDERING A MAJOR EXPANSION PROGRAM THAT HAS BEEN PROPOSED BY THE COMPANYS INFORMATION TECHNOLOGY GROUP. B EFOREPROCEEDING ANESTIMATE OF WITH ITS THE OF EXPANSION, THE COMPANY THAT YOU NEEDS ARE TO AN DEVELOP ASSISTANT

COST

CAPITAL.ASSUME

TOJERRY LEHMAN, THE FINANCIAL VICE-PRESIDENT. YOUR FIRST TASK IS TOESTIMATE COLEMANS COST OF CAPITAL.LEHMAN HAS PROVIDED YOU WITH THEFOLLOWING DATA, WHICH HE BELIEVES MAY BE RELEVANT TO YOUR TASK: 1.THE FIRMS TAX RATE IS 40 PERCENT. 2.THE CURRENT PRICE BONDS NOT OF COLEMANS 15 12 PERCENT REMAINING COUPON, TO SEMIANNUALPAYMENT, IS$1,153.72. ONA PERMANENT

NONCALLABLE COLEMAN DOES

WITH USE

YEARS

MATURITY DEBT

SHORT-TERM

INTEREST-BEARING

BASIS. NEW BONDS WOULD BE PRIVATELY PLACED WITH NO FLOTATION COST. 3.THE CURRENT PRICE OF THE FIRMS 10 PERCENT, $100 PAR VALUE, QUARTERLY DIVIDEND, PERPETUAL PREFERRED STOCK IS $111.10. 4. COLEMANS COMMON STOCK IS CURRENTLY SELLING AT $50 PER SHARE.ITSLAST DIVIDEND (D0) WAS $4.19, AND DIVIDENDS ARE EXPECTED TO GROW ATA CONSTANT RATE OF 5 PERCENT IN THE FORESEEABLE FUTURE.COLEMANSBETA IS 1.2, THE YIELD ON T-BONDS IS 7 PERCENT, AND THE MARKET RISKPREMIUM IS ESTIMATED TO BE 6 PERCENT. FOR THE BONDYIELD-PLUS-RISK-PREMIUM APPROACH, THE FIRM USES A 4 PERCENTAGE POINT RISKPREMIUM. 5. COLEMANS TARGET CAPITAL STRUCTURE IS 30 PERCENT LONG-TERM DEBT, 10 PERCENT PREFERRED STOCK, AND 60 PERCENT COMMON EQUITY. TO STRUCTURE THE TASK SOMEWHAT, LEHMAN HAS ASKED YOU TO ANSWER THE FOLLOWING QUESTIONS. Integrated Case:9 - 12

INTEGRATED CASE Integrated Case:9 - 13 . WHAT SOURCES OF CAPITAL SHOULD BE INCLUDED WHEN YOU ESTIMATE COLEMANS WEIGHTED AVERAGE COST OF CAPITAL (WACC)? ANSWER:[SHOW S9-1 THROUGH S9-3 HERE.]THE WACC IS USED PRIMARILY FOR MAKING LONG-TERM CAPITAL INVESTMENT DECISIONS, i.e., FOR CAPITAL BUDGETING.THUS, THE WACC SHOULD INCLUDE THE TYPES OF CAPITAL USED TO PAY FORLONG-TERM ASSETS, AND THIS IS TYPICALLY LONG-TERM DEBT, PREFERREDSTOCK (IF USED), AND COMMON STOCK. SHORT-TERM SOURCES OF CAPITAL CONSIST OF (1) SPONTANEOUS, NONINTEREST-BEARING LIABILITIES SUCH AS ACCOUNTSPAYABLE AND ACCRUED LIABILITIES AND (2) SHORT-TERM INTEREST-BEARINGDEBT, SUCH AS NOTES PAYABLE. IF THE FIRM USES SHORT-TERM INTEREST-BEARING DEBT TO ACQUIRE FIXED ASSETS RATHER THAN JUST TO

FINANCEWORKING CAPITAL NEEDS, THEN THE WACC SHOULD INCLUDE A SHORT-TERM DEBTCOMPONENT. THECOST OF NONINTEREST-BEARING ESTIMATE DEBT IS GENERALLY FUNDS NOT ARE INCLUDED NETTED IN OUT

CAPITAL

BECAUSE

THESE

WHENDETERMINING INVESTMENT NEEDS, THAT IS, NET OPERATING RATHER THAN GROSSOPERATING WORKING CAPITAL IS INCLUDED IN CAPITAL EXPENDITURES. A. 2. SHOULD THE COMPONENT COSTS BE FIGURED ON A BEFORE-TAX OR AN AFTER-TAX BASIS? ANSWER:[SHOW S9-4 HERE.] STOCKHOLDERS ARE CONCERNED PRIMARILY WITH THOSE CORPORATE CASH FLOWS THAT ARE AVAILABLE FOR THEIR USE, NAMELY, THOSE CASH FLOWS AVAILABLE TO PAY DIVIDENDS OR FOR REINVESTMENT. S INCEDIVIDENDS ARE PAID FROM AND REINVESTMENT IS MADE WITH AFTER-TAXDOLLARS,

ALL CASH FLOW AND RATE OF RETURN CALCULATIONS SHOULD BE DONEON AN AFTER-TAX BASIS. A. 3.SHOULD THE COSTS BE HISTORICAL (EMBEDDED) COSTS OR NEW (MARGINAL) COSTS? ANSWER:[SHOW S9-5 AND S9-6 HERE.] IN FINANCIAL MANAGEMENT, THE COST OF CAPITAL IS USED PRIMARILY TO MAKE DECISIONS THAT INVOLVE RAISING NEW CAPITAL. THUS, THE RELEVANT COMPONENT COSTS ARE TODAYS MARGINAL COSTS RATHER THAN HISTORICAL COSTS. Integrated Case:9 - 14 B. WHAT IS THE MARKET INTEREST RATE ON COLEMANS DEBT AND ITS COMPONENT COST OF DEBT? ANSWER:[SHOW S9-7 THROUGH S9-9 HERE.] COLEMANS 12 PERCENT BOND WITH 15 YEARS TO MATURITY IS CURRENTLY SELLING FOR $1,153.72. THUS, ITS YIELD TO MATURITY IS 10 PERCENT: 0 1 2 3 29 30 | | | | | | -1,153.72 60 60 60 60 60 1,000 ENTER N = 30, PV = -1153.72, PMT = 60, AND FV = 1000, AND THEN PRESSTHE I BUTTON TO FIND kd/2 = I = 5.0%.SINCE THIS IS A SEMIANNUAL RATE,MULTIPLY BY 2 TO FIND THE ANNUAL RATE, kd = 10%, THE PRE-TAX COST OF DEBT.

SINCE INTEREST IS TAX DEDUCTIBLE, UNCLE SAM, IN EFFECT, PAYS PARTOF THE COST, AND COLEMANS RELEVANT COMPONENT COST OF DEBT IS THEAFTER-TAX COST: kd(1 - T) = 10.0%(1 - 0.40) = 10.0%(0.60) = 6.0%. OPTIONAL QUESTION SHOULD YOU USE THE NOMINAL COST OF DEBT OR THE EFFECTIVE ANNUAL COST? ANSWER:OUR 10 PERCENT PRE-TAX ESTIMATE IS THE NOMINAL COST OF DEBT. SINCE THE FIRMS DEBT HAS SEMIANNUAL COUPONS, ITS EFFECTIVE ANNUAL RATE IS 10.25 PERCENT: (1.05)2 - 1.0 = 1.1025 - 1.0 = 0.1025 = 10.25%. HOWEVER, NOMINAL RATES ARE GENERALLY USED. THE REASON IS THAT THECOST OF CAPITAL IS USED IN CAPITAL BUDGETING, AND CAPITAL BUDGETINGCASH FLOWS ARE GENERALLY ASSUMED TO OCCUR AT YEAR-END. T HEREFORE,USING NOMINAL RATES MAKES THE TREATMENT OF THE CAPITAL

BUDGETINGDISCOUNT RATE AND CASH FLOWS CONSISTENT. C. 1. WHAT IS THE FIRMS COST OF PREFERRED STOCK? Integrated Case:9 - 15 HOW S9-10 THROUGH S9-12 HERE.] SINCE THE PREFERRED ISSUE IS PERPETUAL, ITS COST IS ESTIMATED AS FOLLOWS: %. 0 . 9 090 . 0 10 . 111 $ 10 $ 10 . 111

$ ) 100 ($ 1 . 0 P D k pp p = = = = = NOTE (1) THAT SINCE PREFERRED DIVIDENDS ARE NOT TAX DEDUCTIBLE TO

THEISSUER, THERE IS NO NEED FOR A TAX ADJUSTMENT, AND (2) THAT WE COULDHAVE ESTIMATED THE EFFECTIVE ANNUAL COST OF THE PREFERRED, BUT AS INTHE CASE OF DEBT, THE NOMINAL COST IS GENERALLY USED. C. C 2. COLEMANS PREFERRED STOCK IS RISKIER TO INVESTORS THAN ITS DEBT, YETTHE PREFERREDS YIELD TO INVESTORS IS LOWER THAN THE YIELD TO MATURITYON THE DEBT.DOES THIS SUGGEST THAT YOU HAVE MADE A MISTAKE?(HINT:THINK ABOUT TAXES.) ANSWER:[SHOW S9-13 THROUGH S9-15 HERE.] CORPORATE INVESTORS OWN MOST PREFERRED STOCK,BECAUSE 70 PERCENT OFPREFERRED DIVIDENDSRECEIVEDBYCORPORATIONS ARE NONTAXABLE. THEREFORE, PREFERRED OFTEN HAS A LOWERBEFORE-TAX YIELD THAN THE BEFORE-TAX YIELD ON DEBT ISSUED BY THE SAMECOMPANY. NOTE, THOUGH, THAT THE AFTER-TAX YIELD TO A CORPORATEINVESTOR AND THE AFTER-TAX COST TO THE ISSUER ARE HIGHER ON PREFERREDSTOCK THAN ON DEBT.

D.1. WHY IS THERE A COST ASSOCIATED WITH RETAINED EARNINGS? ANSWER:[SHOW S9-16 THROUGH S9-18 HERE.] COLEMANS EARNINGS CAN EITHER BERETAINED AND REINVESTED IN THE BUSINESS OR PAID OUT AS DIVIDENDS.IFEARNINGS ARE RETAINED, COLEMANS SHAREHOLDERS FORGO THE OPPORTUNITY TORECEIVE CASH AND TO REINVEST IT IN STOCKS, BONDS, REAL ESTATE, AND THELIKE.THUS, COLEMAN SHOULD EARN ON ITS RETAINED

EARNINGS AT LEAST ASMUCH AS ITS STOCKHOLDERS THEMSELVES COULD EARN ON ALTERNATIVEINVESTMENTS OF EQUIVALENT RISK. FURTHER, THE COMPANYS STOCKHOLDERSCOULD INVEST IN COLEMANS OWN COMMON STOCK, WHERE THEY COULD EXPECT TOEARN ks.WE CONCLUDE THAT RETAINED EARNINGS HAVE AN OPPORTUNITY COST THAT IS EQUAL TO ks, THE RATE OF RETURN INVESTORS EXPECT ON THE FIRMS COMMON STOCK.

Integrated Case:9 - 16THAT IS EQUAL TO ks, THE RATE OF RETURN INVESTORS EXPECT ON THE FIRMS COMMON STOCK. D 2 WHAT IS COLEMANS ESTIMATED COST OF COMMON EQUITY USING THE CAPM APPROACH? ANSWER:[SHOW S9-19 HERE.] THE CAPM ESTIMATE FOR COLEMANS COST OF COMMON EQUITY IS 14.2 PERCENTD 2

THAT IS EQUAL TO ks, THE RATE OF RETURN INVESTORS EXPECT ON THE FIRMS COMMON STOCK. D.2.WHAT IS COLEMANS ESTIMATED COST OF COMMON EQUITY USING THE CAPM APPROACH? ANSWER:[SHOW S9-19 HERE.] THE CAPM ESTIMATE FOR COLEMANS COST OF COMMON EQUITY IS 14.2 PERCENT: ks = kRF + (kM - kRF)b = 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2

E. WHAT IS THE ESTIMATED COST OF COMMON EQUITY USING THE DISCOUNTED CASH FLOW (DCF) APPROACH? ANSWER:[SHOW S9-20 THROUGH S9-22 HERE.] SINCE COLEMAN IS A CONSTANT GROWTH STOCK, THE CONSTANT GROWTH MODEL CAN BE USED:

THAT IS EQUAL TO ks, THE RATE OF RETURN INVESTORS EXPECT ON THE FIRMS COMMON STOCK. D. 2.WHAT IS COLEMANS ESTIMATED COST OF COMMON EQUITY USING THE CAPM APPROACH? ANSWER:[SHOW S9-19 HERE.] THE CAPM ESTIMATE FOR COLEMANS COST OF COMMON EQUITY IS 14.2 PERCENT: ks = kRF + (kM - kRF)b = 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%. E. WHAT IS THE ESTIMATED COST OF COMMON EQUITY USING THE DISCOUNTED CASH FLOW (DCF) APPROACH? ANSWER:[SHOW S9-20 THROUGH S9-22 HERE.] SINCE COLEMAN IS A CONSTANT GROWTH STOCK, THE CONSTANT GROWTH MODEL CAN BE USED: s k = s k= 05 . 0 50 $ ) 05 . 1 ( 19 . 4 $ P

) g 1 ( D g P D 0 0 01 + + + = + = %. 8 . 13 % 0 . 5 % 8 . 8 05 . 0 088 . 0 05 . 0 5

\THAT IS EQUAL TO ks, THE RATE OF RETURN INVESTORS EXPECT ON THE FIRMS COMMON STOCK. D. 2.WHAT IS COLEMANS ESTIMATED COST OF COMMON EQUITY USING THE CAPM APPROACH? ANSWER:[SHOW S9-19 HERE.] THE CAPM ESTIMATE FOR COLEMANS COST OF COMMON EQUITY IS 14.2 PERCENT: ks = kRF + (kM - kRF)b = 7.0% + (6.0%)1.2 = 7.0% + 7.2% = 14.2%. E. WHAT IS THE ESTIMATED COST OF COMMON EQUITY USING THE DISCOUNTED CASH FLOW (DCF) APPROACH? ANSWER:[SHOW S9-20 THROUGH S9-22 HERE.] SINCE COLEMAN IS A CONSTANT GROWTH STOCK, THE CONSTANT GROWTH MODEL CAN BE USED: s k = s k= 05 . 0 50 $ ) 05 . 1 ( 19 . 4 $ P )

g 1 ( D g P D 0 0 01 + + + = + = %. 8 . 13 % 0 . 5 % 8 . 8 05 . 0 088 . 0 05 .

0 50 $ 40 . 4 $ = + = + = + F.FFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFFF FFFF WHAT IS THE BOND-YIELD-PLUS-RISK-PREMIUM ESTIMATE FOR COLEMANS COST OF COMMON EQUITY? ANSWER:[SHOW S9-23 HERE.] THE BOND-YIELD-PLUS-RISK-PREMIUM ESTIMATE IS 14 PERCENT: ks = BOND YIELD + RISK PREMIUM = 10.0% + 4.0% = 14.0%. NOTE THAT THE RISK PREMIUM REQUIRED IN THIS METHOD IS DIFFICULT

TOESTIMATE, SO THIS APPROACH ONLY PROVIDES A BALLPARK ESTIMATE OF ks.IT IS USEFUL, THOUGH, AS A CHECK ON THE DCF AND CAPM ESTIMATES, WHICHCAN, UNDER CERTAIN CIRCUMSTANCES, PRODUCE UNREASONABLE ESTIMATES.

G.GGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGGG GGG

WHAT IS YOUR FINAL ESTIMATE FOR ks? Integrated Case:9 - 17 THE FOLLOWING TABLE SUMMARIZES THE ks ESTIMATES: TTAAAAAAABBBLLLLLLLLLLLLEEEEEEEEEEEEEEEE

AT THIS POINT, CONSIDERABLE JUDGMENT IS REQUIRED. IF A METHOD ISDEEMED TO BE INFERIOR DUE TO THE QUALITY OF ITS INPUTS, THEN ITMIGHT BE GIVEN LITTLE WEIGHT OR EVEN DISREGARDED. I N OUR EXAMPLE,THOUGH, THE THREE METHODS PRODUCED RELATIVELY CLOSE

RESULTS, SO WEDECIDED TO USE THE AVERAGE, 14 PERCENT, AS OUR ESTIMATE FOR COLEMANSCOST OF COMMON EQUITY HHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHHH EXPLAIN IN WORDS WHY NEW COMMON STOCK HAS A HIGHER PERCENTAGE COST THAN RETAINED EARNINGS. ANSWER:[SHOW S9-25 HERE.] THE COMPANY IS RAISING MONEY IN ORDER TO MAKE ANINVESTMENT. THE MONEY HAS A COST, AND THIS COST IS BASED PRIMARILY ONTHE INVESTORS REQUIRED RATE OF RETURN, CONSIDERING RISK ANDALTERNATIVE INVESTMENT OPPORTUNITIES. SO, THE NEW INVESTMENT MUST PROVIDE A RETURN AT LEAST EQUAL TO THE INVESTORS OPPORTUNITY COST. IF THE COMPANY RAISES CAPITAL BY SELLING STOCK, THE COMPANY

DOESNTGET ALL OF THE MONEY THAT INVESTORS PUT UP. FOR EXAMPLE, IF

INVESTORSPUT UP $100,000, AND IF THEY EXPECT A 15 PERCENT RETURN ON THAT$100,000, THEN $15,000 OF PROFITS MUST BE GENERATED. BUT IF

FLOTATIONCOSTS ARE 20 PERCENT ($20,000), THEN THE COMPANY WILL RECEIVE ONLY$80,000 OF THE $100,000 INVESTORS PUT UP. THAT $80,000 MUST

THENPRODUCE A $15,000 PROFIT, OR A $15/$80 = 18.75% RATE OF RETURN VERSUSA 15 PERCENT RETURN ON EQUITY RAISED AS RETAINED EARNINGS.

I.IIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIIII

1.WHAT ARE TWO APPROACHES THAT CAN BE USED TO ACCOUNT FOR FLOTATION COSTS? ANSWER:THE FIRST APPROACH IS TO INCLUDE THE FLOTATION COSTS AS PART OF THE PROJECTS UP-FRONT COST.THIS REDUCES THE PROJECTS ESTIMATED RETURN. THE SECOND APPROACH IS TO ADJUST THE COST OF CAPITAL TO INCLUDE Integrated Case:9 18

TABLEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEEE

FLOTATION COSTS. THIS IS MOST COMMONLY DONE BY INCORPORATING FLOTATION COSTS IN THE DCF MODEL. I. 2.COLEMAN ESTIMATES THAT IF IT ISSUES NEW COMMON STOCK, THE FLOTATION COST WILL BE 15 PERCENT. COLEMAN INCORPORATES THE FLOTATION COSTS INTO THE DCF APPROACH. WHAT IS THE ESTIMATED COST OF NEWLY ISSUED COMMON STOCK, TAKING INTO ACCOUNT THE FLOTATION COST? ANSWER:[SHOW S9-26 AND S9-27 HERE.] %. 35

15. = 5.0% + $42.50 $4.40 = 5.0% + 0.15) $50(1 ) $4.19(1.05 = g + F) (1 P g) + (1 D = k

JJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJJ J..REFER TO YOUR PAPER KKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKKK PAPER

TAX RATES FACTORS THE FIRM CAN CONTROL: CAPITAL STRUCTURE POLICY DIVIDEND POLICY INVESTMENT POLICY L.LLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLLL

SHOULD THE COMPANY OF ITS PROJECTS? ANSWER:[SHOW S9-30 NO. THE COMPOSITE WACC RISK OF AN AVERAGE

USE THE COMPOSITE WACC AS THE HURDLE RATE FOR EACH AND S9-31 HERE.] REFLECTS THE PROJECT UNDERTAKEN BY THE FIRM. T

HEREFORE, THEWACC ONLY REPRESENTS THE HURDLE RATE FOR A TYPICAL PROJECT WITHAVERAGE RISK.DIFFERENT PROJECTS HAVE DIFFERENT RISKS.THE

PROJECTSWACC SHOULD BE ADJUSTED TO REFLECT THE PROJECTS RISK.

WHAT ARE THREE TYPES OF PROJECT RISK?HOW IS EACH TYPE OF RISK USED? ANSWER:[SHOW S9-32 THROUGH S9-34 HERE.]THE THREE TYPES OF PROJECT RISK ARE: STAND-ALONE RISK CORPORATE RISK MARKET RISK MARKET RISK IS THEORETICALLY BEST IN MOST SITUATIONS. HOWEVER,CREDITORS, CUSTOMERS, SUPPLIERS, AND EMPLOYEES ARE MORE AFFECTED BYCORPORATE RISK. THEREFORE, CORPORATE RISK IS ALSO RELEVANT. STAND-ALONE RISK IS THE EASIEST TYPE OF RISK TO MEASURE. TAKING ORCORPORATE RISK.HOWEVER, ON A PROJECT WILL THE WITH NOT A HIGH DEGREE OF EITHER THE STAND-ALONE MARKET AND IF

RISK IF

NECESSARILY HAS HIGHLY

AFFECT

FIRMS

PROJECT

UNCERTAIN

RETURNS,

THOSERETURNS ARE HIGHLY CORRELATED WITH RETURNS ON THE FIRMS OTHER ASSETSAND WITH MOST OTHER ASSETS IN THE ECONOMY, THE PROJECT WILL HAVE AHIGH DEGREE OF ALL TYPES OF RISK.

WHAT ARE THREE TYPES OF PROJECT RISK?HOW IS EACH TYPE OF RISK USED? ANSWER:[SHOW S9-32 THROUGH S9-34 HERE.]THE THREE TYPES OF PROJECT RISK ARE: STAND-ALONE RISK CORPORATE RISK MARKET RISK MARKET RISK IS THEORETICALLY BEST IN MOST SITUATIONS. HOWEVER,CREDITORS, CUSTOMERS, SUPPLIERS, AND EMPLOYEES ARE MORE AFFECTED BYCORPORATE RISK. THEREFORE, CORPORATE RISK IS ALSO RELEVANT. STAND-ALONE RISK IS THE EASIEST TYPE OF RISK TO MEASURE. TAKING ORCORPORATE ON A PROJECT WILL WITH NOT A HIGH DEGREE OF EITHER THE STAND-ALONE MARKET

RISK

NECESSARILY

AFFECT

FIRMS

RISK.HOWEVER,

IF

THE

PROJECT

HAS

HIGHLY

UNCERTAIN

RETURNS,

AND

IF

THOSERETURNS ARE HIGHLY CORRELATED WITH RETURNS ON THE FIRMS OTHER ASSETSAND WITH MOST OTHER ASSETS IN THE ECONOMY, THE PROJECT WILL HAVE AHIGH DEGREE OF ALL TYPES OF RISK. COLEMAN IS INTERESTED IN ESTABLISHING A NEW DIVISION, WHICH WILL FOCUS PRIMARILY ON DEVELOPING NEW INTERNET-BASED PROJECTS. I N TRYING TODETERMINE THE COST OF CAPITAL FOR THIS NEW DIVISION, YOU DISCOVER THATSTAND-ALONE FIRMS INVOLVED IN SIMILAR PROJECTS HAVE ON

AVERAGE THEFOLLOWING CHARACTERISTICS: THEIR CAPITAL STRUCTURE IS 40 PERCENT DEBT AND 60 PERCENT COMMON THEIR COST OF DEBT IS TYPICALLY 12 PERCENT. THE BETA IS 1.7. EQUITY.

GIVEN THIS INFORMATION, WHAT WOULD YOUR ESTIMATE BE FOR THE DIVISIONS COST OF CAPITAL? NOTE THAT COLEMAN USES THE CAPM TO CALCULATE THE DIVISIONS COST OF CAPITAL. ANSWER:[SHOW S9-35 THROUGH S9-37 HERE.] ks DIV. = kRF + (kM - kRF)bDIV. = 7% + (6%)1.7 = 17.2%. WACCDIV. = wdkd(1 - T) + wcks = 0.4(12%)(0.6) + 0.6(17.2%) = 13.2%. THE DIVISIONS WACC = 13.2% VS. THE CORPORATE WACC = 11.1%. T HEDIVISIONS MARKET RISK IS GREATER THIS THAN THE WOULD FIRMS BE AVERAGE IF

PROJECTS.TYPICAL

PROJECTS

WITHIN

DIVISION

ACCEPTED

THEIRRETURNS WERE ABOVE 13.2 PERCENT.