CHAPTER 14 Titman/ 12 Keown: Cost of Capital

Page 1 of 5

Home w ork due 10.24. 1 3 ANSWERS + Se a t w o r k

14- 3 (Individu al or compo n e n t costs of capit al) Se a t w o r k W h a t if in italic s
(VYE e x a m p l e s )
14- 22 (WACC)
ANSWERS:
14- 3. Deter mi n e individual cost s for various funding sourc e s .

Note: assu m e

that the bond mak e s annu al inter e s t paym e n t s .

A. Bon d:
par value = $1000
coupo n rate = 11%
mark e t value = $112 5 Vb
ma t urity (ye ar s) = 10
mar gin al tax rate = 34%
To find the mark e ts require d retur n on bonds of this risk class,
1. We find the YTM using the bond pricing mod el:

1 1 10
$1125 = (11%) ($1000) (1+ i )
i

$1,000
,
+
10
(1 + i )

wher e the factor in the squar e bracke t s is the annuity pres e n t value
intere s t factor PVIFA, and the i value is the yield to mat urity (YTM).
Comput e for i, i = 9. 0 5 % , a.k. a k d or k b
2. OR to solve for YTM using Excels RATE function:
= RATE(nper, pmt, PV, FV)
= RATE(10, 110, 1125, 1000), a.k. a
YTM = 9. 0 5 % .
Of cours e , the firms inter e s t paym e n t s are tax deduc tible, so we nee d
one mor e ste p:
tur n this bef or e - tax YTM int o an aft er- tax co s t .
To do this, we simply multiply the YTM by (1 T), wher e T is the firms
mar gin al tax rate (expr e s s e d as a deci mal).
Thus her e we have (9.05%) (1 0.34) = 5.97%.
This is the effective after- tax cost that the firm would pay to issue new
bonds compa r a bl e in risk to thes e 11% bonds .
3. We can us e th e PVIFA & PVIF tabl e s
10

Cos t of de b t k d fro m V b

$1 1 2 5 =

t =1

$110
(1 + k d ) t

$1,000
(1 + k d )10

$1125 = $110 (PVIFAx%, 10 ) + $1,000(PVIF x%, 10 )

(By trial and err or) At 9%,
10

NP = $110 (PVIFA9%, 10 ) + $1,00 0(PVIF 9%,

$110 (6.418) + $1,00 0(. 4 2 2) = $112 8 , quite close to mark e t value

$1125
So k d 9%

CHAPTER 14 Titman/ 12 Keown: Cost of Capital

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Aft er tax co s t of de b t = k d (1- T) = 9% (1- .3 4 ) = 9% * .6 6 =

5. 9 4 %

4. OR us e th e for m u l a :

k b = $ I + $M $MP = $ 11 0 + $1 0 0 0 $ 1 1 2 5
= 9. 1 7%
n
10
$M + $MP
$1 0 0 0 + $1 1 2 5
2
2
Aft er tax co s t of de b t = k d (1- T) = 9. 1 7 % (1- .3 4 ) = 9. 1 7 % * .6 6 =
6%
SEATW O R K :
W h a t if th e r e is a flo a t a t i o n co s t of 5% for a ne w b o n d is s u e ?
NP d = $1 1 2 5 * (1 - .0 5 ) = $1 0 6 8 . 7 5
To co m p u t e for c os t of d e b t k d
10

V b = $1 0 6 8 . 7 5 =

t =1

$110
(1 + k d ) t

$1,000
(1 + k d )10

$1 0 6 8 . 7 5 = $1 1 0 (PVIFA x%, 10 ) + $1, 0 0 0 ( P VIF x%, 10 )

Usi n g th e PVIFA & PVIF ta b l e s
(By tri al an d err o r )
At 9%,
NP
= $1 1 0 (PVIFA 9%, 10 ) + $1, 0 0 0 ( P VIF 9%,

10

= $1 1 0 (6. 4 1 8 ) + $1, 0 0 0 ( . 4 2 2 ) = $1 1 2 8
At 10 % ,

NP

= $1 1 0 (PVIFA 10%,

10

) + $1, 0 0 0 ( P VIF 10%,

10

= $1 1 0 (6. 1 4 5 ) + $1, 0 0 0 ( . 3 8 6 ) = $1 0 6 1 . 9 5
$1 0 6 8 . 7 5
The r e f o r e k d 10 %
Aft e r ta x co s t of d e b t ne t of flo a t a t i o n co s t = k d (1- T) = 10 % (1- .3 4 )
= 10 % * .6 6 = 6. 6 %
OR us e th e for m u l a :

k b = $ I + $M $MP = $ 11 0 + $1 0 0 0 $ 1 0 6 8 . 7 5
n
10
$M + $MP
$1 0 0 0 + $1 0 6 8 . 7 5
2
2
Aft er tax co s t of de b t = k d (1- T) = 10% (1- .3 4 ) = = 6. 6%
Bac k to Ho m e w o r k
B. Com m o n st o c k:
dividen d paid last year = $1.80 = D 0
const a n t growth in dividen d s , per year = 7%
curre nt stock price = $27.50

= 10%

CHAPTER 14 Titman/ 12 Keown: Cost of Capital

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Since this stock is in cons t a n t growth, solve for the cost of com m o n
equity implied by the value s given as follows:
kcs =
=

D1 D0* (1 + g )
=
+g
P0
P0
$1.80 (1.07)
+ 0.07 = 7% + 7% = 14%.
$27.50

(Note that we ass u m e that the divide n d last year is at t = 0, not t =

1, so that we can simply find next years divide n d , D 1 , as $1.80 (1
+ g ).
SEATW O R K:
W h a t if th e r e is a flo a t a t i o n co s t of $2 for a ne w co m m o n s t o c k is s u e ?
If Kc s
= [$ 1 . 8 0 (1. 0 7 ) / $ 2 7 . 5 0 ] + 0. 0 7 = 14 %
K nc s = [$ 1 . 8 0 ( 1 . 0 7 ) / ( $ 2 7 . 5 0 - $2) ] + 0. 0 7 = 14. 6 %
Bac k to Ho m e w o r k
C. Preferr e d stock:
mark e t value = $125
dividen d = 9%
par value = $100
1. Find the cost of preferr e d stock financing,:
Div ps
k ps =
Pps
For our preferr e d, we can find the divide n d as 9% $100 par value = $9.
$9.00
k ps =
= 7.2%
$125
SEATW O R K:
W h a t if th e r e is a flo a t a t i o n co s t of $5 for th e pr e f e r r e d s t o c k ?
K ps

D
NPps

$9
($125 $5)

= 7. 5 %

Bac k to Ho m e w o r k
D.
Bond selling to yield 12%.
The cost of debt before tax is ther efor e 12%.
Howeve r, bec a u s e firms can deduc t inter e s t ,
the after- tax cost of this bond is only (12%) (1 T);
since T = 34%, the after- tax cost is (12%) (1 0.34) = 7.92%.
Aft er tax co s t of de b t = k d (1 - T) = 12% (1 - .3 4 )
SEATW O R K:
W h a t if fut u r e fina n c i n g w e i g h t s ar e as foll o w s :

= 7. 9 2 %

CHAPTER 14 Titman/ 12 Keown: Cost of Capital

Bon d s
Pr e f e r r e d s t o c k 15 %
Co m m o n s t o c k
35 %
Ne w is s u e of c/s 10 %

Page 4 of 5

40 %

Co m p u t e w e i g h t e d av e r a g e co s t of ca p i t a l ( w a c c )
w
k
w x k
Bon d s
40 % x 6. 6 %
= 2. 6 4 %
Pr e f e r r e d s t o c k 15 % x 7. 5
= 1. 1 2 5 %
Co m m o n s t o c k
35 % x 14
= 4. 9 %
Ne w is s u e of c/s 10 % x 14. 6
= 1. 4 6 %
= 10 . 1 2 5 %
14- 22. To find Crypton Electronics WACC, we first mus t find the costs of capit al
for its funding sourc e s , debt and com mo n stock.
A. Its debt has the following char a c t e ri s tics:
par value = $1000
coupo n rate = 6%
mark e t value = $975 Vb
ma t urity (ye ar s) = 15
mar gin al tax rate = 30%
1. Solve for the yield to ma t urit y (YTM, or i) as follows:

1 (1+1i )15 $1000

$975 = (6%) ($1000)
i = 6. 2 6 %
+
15
i

(1 + i)
After tax cost of debt = (6.26%) (1 0.30) = 4.38%.
(Note that we have ass u m e d that the bond mak e s annu al inter e s t
paym e n t s . )
2. Also solve for YTM using Excels RATE function:
= RATE(nper, pmt, PV, FV) = RATE(15, 60, 975, 1000), RATE = 6.26%.
Cryptons debts YTM is gre a t e r than its coupo n rate of 6%, since the
bonds sell at a discount .
Given the 6.26% befor e- tax cost of debt, we find Cryptons after- tax cost
of debt
(6.26%) (1 0.30) = 4.38%.
This is the effective cost to the firm of the 60% of its ass e t s that it
financ e s with debt.
3. OR we can use the PVIFA & PVIF table s
15

Cos t of de b t Vb =

$9 7 5

t =1

$60
(1 + k d ) t

$975 = $60 (PVIFAx%, 15 ) + $1,000(PVIF x%, 15 )

(By trial and error)
At 6%, NP = $60 (PVIFA6%, 15 ) + $1,00 0(PVIF 6%, 15 )

$1,000
(1 + k d )15

CHAPTER 14 Titman/ 12 Keown: Cost of Capital

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$60 (9.712) + $1,00 0(. 4 1 7) = $999. 7 2 , close to Vb= mark e t value =

$975
Kd 6% (before tax cost of debt)
Aft er tax co s t of de b t = k d (1- T) = 6% (1- .3 0 ) = 6% * .7 = 4. 2%
Note: At 7%,

NP = $60 (PVIFA7%, 15 ) + $1,00 0(PVIF 7%, 15 )

$60 (9.108) + $1,00 0(. 3 6 2) = $908. 4 8, not as close to Vb = mark e t value

= $975
B. To find the cost of Cryptons com m o n stock:
dividen d next year = $2.25 = D 1
const a n t growth in dividen d s , per year = 7%
curre nt stock price = $30

kcs =

D1
+g
P0

$2.25
+ 0.05
$30.00
= 7.50% + 5% = 12.50%.
=

Cryptons stock offers a 7.5% divide n d yield

(calcula t e d as the ratio of its project e d divide nd for next ye ar, $2.25, to its curre n t
stock price, $30) and its 5% capit al gains yield (the rate of sust ai n a bl e growt h in
Cryptons stock).
Thus the firm pays 12.5% on the 40% of its ass e t s that it financ e s with equity.
C. To get a fter- tax costs for both of Cryptons funding source s, find its WACC as
follows:
tax rate = 30%
A
capital structure
weights
common stock
40%
debt
60%
100%

B
before-tax
component
costs
12.50%
6.26%

D = A*C

after-tax
component
weighted
costs
after-tax cost
12.50%
5.00%
4.38%
2.63%
= (6.26%)*(1-.30)
7.63%
WACC

Cryptons WACC is 7.63%, betw e e n its after- tax cost of debt and its cost of
equity.
Crypton should not acce p t any (aver a g e - risk) project whos e retur n is less
tha n 7.63%.