19. Opportunity cost of capital (S18-1) Suppose the project described in Problem 18 is to be undertaken by a university. Funds for the project will be withdrawn from the university’s endowment, which is invested in a widely diversified portfolio of stocks and bonds. However, the university can also borrow at 7%. The university is tax-exempt.

The university treasurer proposes to finance the project by issuing $400,000 of perpetual bonds at 7% and by selling $600,000 worth of common stocks from the endowment. The expected return on the common stocks is 10%. He therefore proposes to evaluate the project by discounting at a weighted-average cost of capital, calculated as r

=

r D D / V + r E E / V

= 0.07 ( 400,000 / 1,0 00,000) + 0.10 ( 600,000/1,000,000 )

=

0.088, or 8.8%