P9-1. Concept of cost of capital

LG 1; Basic

a. The firm is basing its decision on the cost to finance a particular project rather than the firms combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions.

b.

ra =0.40 (7%) + 0.60(16%)

ra =2.8% + 9.6%

ra =12.4%

c. Reject project 263. Accept project 264.

d. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as a criterion provides better decisions because it takes into consideration the long-run interrelationship of financing decisions

9-6

After-tax cost of debt

a. Since the interest on the boat loan is not tax deductible, its after-tax cost equals its stated cost of 8%.

b. Since the interest on the second mortgage is tax deductible, its after-tax cost is found by multiplying the before-tax cost of debt by (1 - tax rate). Being in the 28% tax bracket, the after-tax cost = 9.2% (1-.28) = 6.62%

c. Home equity loan has a lower after-tax cost. However, using the second home mortgage does put the Starks at risk of losing their home if they are unable to make the mortgage payments.

P9-7. Cost of preferred stock: rp = Dp / Np

Cost of preferred stock: rp = Dp / Np

a. 12.63%

b. 11.11%

P9-9. Cost of common stock equitycapital asset pricing model (CAPM)

LG 5; Intermediate

rs = RF + [b (rm - RF)]

rs = 6% + 1.2 (11% - 6%)

rs = 12%

a. Risk premium = 6%

b. Rate of return = 12%

c. After-tax cost of common equity using the CAPM = 12%

P9-10. Cost of common stock equity:

LG 5; Intermediate

a. Dont worry about solving for the growth rate it = 9.97%

b. Nn = $52 (given in the problem)

c. rr = (Next Dividend / Current Price) + growth rate

rr = ($3.40 / $57.50) + 0.0997

rr = 0.0591 + 0.0997 = 0.1588 or 15.88%

d. rn = ($3.40 / $52) + 0.0997

rn = 0.0654 + 0.0997 = 0.1651 or 16.51%

P9-11. Retained earnings versus new common stock

LG 5; Intermediate

Firm Calculation

A rr = ($2.25/ $50.00) + 8% = 12.50%

rn = ($2.25 / $47.00) + 8% = 12.79%

B rr ($1.00 / $20.00) + 4% = 9.00%

rn = ($1.00 /$18.00) + 4% = 9.56%

P9-12. Effect of tax rate on WACC

LG 3, 4, 5, 6; Intermediate

a. WACC = (0.30)[(11%)(1 - 0.40)] + (0.10x9%) + (0.60x14%)

WACC = 1.98% + 0.9% + 8.4%

WACC = 11.28%

b. WACC (0.30)[(11%)(1 - 0.35)] + (0.10x9%) + (0.60x14%)

WACC = 2.15% + 0.9% + 8.4%

WACC = 11.45%

c. WACC = [(0.30)(11%)(1 - 0.25)] + (0.10x9%) + (0.60x14%)

WACC = 2.48% + 0.9% + 8.4%

WACC = 11.78%

d. As the tax rate decreases, the WACC increases due to the reduced tax shield from the tax-deductible interest on debt.