18. Suppose the project described in Problem 17 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 Funds for the project will be withdrawn from the university’s endowment, which is invested in a widely diversified portfolio of stocks and bonds.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 ⫽ rD D

V

⫹ rE E

V

⫽ .07a 400,000 1,000,000 b ⫹ .10a 600,000 1,000,000 b

⫽ .088, or 8.8 What’s right or wrong with the treasurer’s approach? Should the university invest? Should it borrow? Would the project’s value to the university change if the treasurer financed the project entirely by selling common stocks from the endowment?