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Chapter 11
Cost of Capital
2.
Cost of capital (LO2) Speedy Delivery Systems can buy a piece of equipment that is
anticipated to provide an 8 percent return and can be financed at 5 percent with debt. Later
in the year, the firm turns down an opportunity to buy a new machine that would yield a 15
percent return but would cost 17 percent to finance through common equity. Assume debt
and common equity each represent 50 percent of the firm’s capital structure.
a. Compute the weighted average cost of capital.
b. Which project(s) should be accepted?
11-2. Solution:
Speedy Delivery Systems
a.
Cost
Debt
Common equity
Weighted average cost of
capital
5%
17%
Weighted
Weights
Cost
50%
50%
2.5%
8.5%
11%
b. Only the new machine with a return of 17 percent.
The return exceeds the weighted average cost of capital of
11.0 percent.
8.
Aftertax cost of debt (LO3) Royal Jewelers Inc., has an aftertax cost of debt of 6 percent.
With a tax rate of 40 percent, what can you assume the yield on the debt is?
11-8. Solution:
Regal Jewelers, Inc.
K d  Yield 1  T 
9.
Yield =
Kd
1  T 
Yield =
6%
6%

 10%
1  .40  .60
Approximate yield to maturity and cost of debt (LO3) Airborne Airlines, Inc., has a
$1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual
interest payment of $78 and is currently selling for $875. Airborne is in a 30 percent tax
bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be.
The yield to maturity on the new issue will be the same as the yield to maturity on the old
issue because the risk and maturity date will be similar.
a. Compute the approximate yield to maturity (Formula 11-1) on the old issue and use
this as the yield for the new issue.
b. Make the appropriate tax adjustment to determine the aftertax cost of debt.
11-9. Solution:
Airborne Airlines, Inc.
Principal payment  Price of the bond
Number of years to maturity
.6 (Price of bond)  .4 (Principal payment)
Annual interest payment 
a.
Y' 
$1,000  $875
25

.6  $875   .4  $1,000 
$78 
$125
25

$525  $400
$78  $5

$925
$83

 8.97%
$925
$78 
b. Kd = Yield (1 – T)
= 8.97% (1 – .30)
= 8.97% (.70)
= 6.28%
13.
Cost of preferred stock (LO3) Medco Corporation can sell preferred stock for $80 with
an estimated flotation cost of $3. It is anticipated the preferred stock will pay $6 per share
in dividends.
a. Compute the cost of preferred stock for Medco Corp.
b. Do we need to make a tax adjustment for the issuing firm?
11-13. Solution:
Medco Corporation
a.
Kp 

Dp
Pp  F
$6
$6

 7.79%
$80  $3 $77
b. No tax adjustment is required. Preferred stock dividends are
not a tax deductible expense for the issuing firm (the
dividends, of course, are 70 percent tax exempt to a
corporate recipient).
15.
Comparison of the costs of debt and preferred stock (LO3) The treasurer of Riley Coal
Co. is asked to compute the cost of fixed income securities for her corporation. Even before
making the calculations, she assumes the aftertax cost of debt is at least 2 percent less than
that for preferred stock. Based on the facts below, is she correct?
Debt can be issued at a yield of 10.6 percent, and the corporate tax rate is 35 percent. Preferred
stock will be priced at $50 and pay a dividend of $4.40. The flotation cost on the preferred
stock is $2.
11-15. Solution:
Riley Coal Inc.
Aftertax cost of debt
K d  Yield (1  T)
=10.6%(1  .35) = 10.6% (.65) = 6.89%
Aftertax cost of preferred stock
Kp 
Dp
Pp  F

$4.40
$4.40

 9.17%
$50  $2 $48
Yes, the treasurer is correct. The difference is 2.28% (6.89%
versus 9.17%).
16.
Costs of retained earnings and new common stock (LO3) Barton Electronics wants you
to calculate its cost of common stock. During the next 12 months, the company expects to
pay dividends (D1) of $1.20 per share, and the current price of its common stock is $30 per
share. The expected growth rate is 9 percent.
a. Compute the cost of retained earnings (Ke). Use Formula 11-6.
b. If a $2 flotation cost is involved, compute the cost of new common stock (Kn). Use
Formula 11-7.
11-16. Solution:
Barton Electronics
a.
Ke 
=
b.
Kn 
D1
g
P0
$1.20
 9%  4%  9%  13%
$30
D1
g
P0  F
$1.20
$1.20
 9% 
 9%
$30  $2
$28
 4.29%  9%  13.29%
=
19.
Weighted average cost of capital (LO1) United Business Forms’ capital structure is as
follows:
Debt ............................
Preferred stock ...........
Common equity..........
35%
15
50
The aftertax cost of debt is 7 percent; the cost of preferred stock is 10 percent; and the cost
of common equity (in the form of retained earnings) is 13 percent.
Calculate United Business Forms’ weighted average cost of capital in a manner similar
to Table 11-1.
11-19. Solution:
United Business Forms
Cost
(aftertax) Weights
Debt (Kd) ......................................
7.0%
35%
Preferred stock (Kp)......................
10.0
15
Common equity (Ke)
(retained earnings) ........................
13.0
50
Weighted average cost of
capital (Ka) ...................................
Weighted
Cost
2.45%
1.50
6.50
10.45%