CHAPTER 12

Cost of Capital
ANSWERS TO
END-OF-CHAPTER QUESTIONS

12-1. The cost of capital is the rate that must be earned on investments in order to satisfy
the required rate of return of the firm's investors. This rate is a function of the
investors' required rate of return, the corporation's tax rate, and the flotation costs
incurred in issuing new securities. Therefore, the cost of capital determines the rate
of return that must be achieved on the company's investments, so as to earn the
target return of the firm's investors. Stated differently, the cost of capital is the rate
of return that will leave the price of the common stock unchanged.
12-2. Two objectives may be given for determining a company's weighted average cost of
capital:
(1) The weighted average cost of capital is used as the minimum acceptable rate
of return for capital investments. The value of the firm should be maximized
by accepting all projects where the net present value is positive when
discounted at the firm's weighted average cost of capital.
(2) The weighted average cost of capital is also used in evaluating a firm’s
historical performance. That is, to create shareholder value a firm must not
only earn a profit in the traditional accounting sense, but it must earn a return
on its invested capital that is acceptable to the investors who provide the
firm’s financing. This “acceptable return” is the firm’s weighted average
cost of capital.
12-3. All types of capital, including debt, preferred stock, and common stock, should be
incorporated into the cost of capital computation, with the relative importance of a
particular source being based upon the percentage of financing to be provided.
12-4. The effect of taxes on the firm's cost of capital is observed in computing the cost of
debt. Since interest is a tax deductible expense, the use of debt indirectly decreases
the firm's taxes. Therefore, since we have computed the internal rate of return on an
after-tax basis, we also compute the cost of debt on an after-tax basis. In completing
a security offering, investment bankers and other involved individuals receive a
commission for their services. As a result, the amount of capital net of these
flotation costs is less than the funds invested by the individual purchasing the
security. Consequently, the firm must earn more than the investors' required rate of
return to compensate for this leakage of capital.

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12-5. a. Equity capital can be raised by either retaining profits within the firm or by
issuing new common stock. Either route represents funds invested by the
common stockholder. The first avenue simply indicates that the common
stockholder permits management to retain capital that could be remitted to
these investors.
b. Even though a new stock issue does not result from retaining internal
common equity, these funds should not be reinvested unless management can
reasonably expect to satisfy the investors' required rate of return. In essence,
even though no explicit out-of-pocket cost results from retaining the capital,
the cost in measuring a firm's cost of capital is actually the opportunity cost
associated with these funds for the investor.
c. The two popular methods for computing the cost of equity capital include (1)
the dividend-growth model, and (2) the capital asset pricing model. The first
approach finds the rate of return that equates the present value of future
dividends, assuming a constant growth rate, with the current market price of
the security. The CAPM finds the appropriate required rate of return, given
the firm's systematic risk.
12-6 In general, the relative costs of various sources of capital reflect the riskness of the
source to the investor. For example, for a given firm, we would expect debt
securities to be less risky than preferred stock which is less risky than common
stock. Consequently, debt would demand a lower required return than the firm’s
preferred stock, which is lower than the required rate of return for common stock.

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 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
The following notations are used in this group of problems:
kps = the cost of preferred stock.
kcs = the cost of internally generated common funds
kncs = the cost of new common stock.
g = the growth rate.
kd = the before-tax cost of debt.
T = the marginal tax rate.
Dt = dollar dividend per share, where Do is the most recently paid
dividend and D1 is the forthcoming dividend.
P = the value (present value) of a security.
NP = the value of a security less any flotation costs incurred in issuing the
security
12-1A.
a. Net price after flotation costs = $1,125 (1 - .05)

= $1068.75
10
$110 $1,000
$1068.75 = ∑
t =1 (1 + k d ) t +
(1 + k d )10

kd = 9.89%

= kd(1-T)

= 6.53%

D1
b. kncs = + g
NPcs

$1.80 (1 +.07 )
= $27 .50 (1 −.05 )
+ .07

= .1437 = 14.37%

D1
c. kcs = + g
Pcs

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 $3.50
= + .07
$43

= .1514 = 15.14%
D .09 x$150
d. kps = NP ps
=
$175 (1 −.12 )

$13 .50
=
$154

= .0877 = 8.77%

After tax
e. cost of debt = kd (1 - T)

= 12% (1 - .34)

= 7.92%
12-2A.

After tax
a. cost of debt = kd(1 - T)

= 8%(1 - 0.34)

= 5.28%

D1
b. kncs = + g
NP cs

$1.05 (1 +0.05 )
kncs = + 0.05= 9.85%
$25 (1 −0.09 )

c. $1,150(.90) = $1,035 = net price after flotation costs

20
$120 $1,000
$1,035 = ∑
t =1 (1 + kd) t
+
(1 + k d ) 20

Rate Value Value

53
 For: 11% $1,079.56 $1,079.56

kd% 1,035.00

12% 1,000.00

$ 44.56 $ 79.56

0.11 + 
$44 .56 
kd =   × 0.01 = .1156 = 11.56%
 $79 .56 

After tax
cost of debt = kd (1 - T)

After tax
cost of debt = 11.56% (1 - 0.34) = 7.63%

D
d. kps =
NP ps

$7
kps = = 8.24%
$85

D1
e. kcs = + g
Pcs

$3
kcs = + 0.04 = 11.90%
$38

D1
12-3A. kncs = + g
NPcs

$1.45 (1 +0.06 )
kncs = + 0.06 = .1206 = 12.06%
$27 (1 −0.06 )

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12-4A. $958 (1 - 0.11) = $852.62 = the net price (value less flotation
costs).

15 $70 $1,000
$852.62 = ∑ +
t =1 (1 + k d ) t (1 + k d )15

Rate Value Value

For: 8% $914.20 $914.13
kd% 852.62
9% ______ 839.27
$61.58 $74.86

0.08 + 
$61 .58 
kd =   × 0.01 = .0882 =
 $74 .86 
8.82%

= 8.82% (1 - 0.18) = 7.23%

D $2.50
12-5A. kps = = = 7.69%
NP ps $32 .50

n $I t $M
12-6A. NPd = ∑ +
t =1 (1 + k d ) t (1 + k d ) n

15 $120 $1,000
$945 = ∑ +
t =1 (1 + k d ) t (1 + k d )15

Since the net price on the bonds, $945, is less than the $1,000 par value, the before-
tax cost of the debt must be greater than the 12 percent coupon interest rate ($120 ÷
$1,000).
Rate Value Value
12% $1,000.00 $1,000.00
kd% 945.00
13% _______ 935.44
$ 55.00 $ 64.56

.12 + 
$55 .00 
kd =   × .01 = .1285 = 12.85%
 $64 .56 

After tax
cost of debt = kd(1 - T) = 12.85%(1 - .34) = 8.48%

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12-7A. Cost of preferred stock (kps)
Dividend D
kps = = NP
Net Price ps

14% x $100 $14

= =
$98 $98
= 14.29%

D1
12-8A. kcs = + g
Pcs

$0.70 (1 + 0.15 )
= + 0.15
$21 .50

= .1874 = 18.74%

12-9A.If the firm pays out 50 percent of its earnings in dividends, its recent earnings must
have been $8 ($4 dividend divided by .5).

Thus, earnings increased from $5 to $8 in five years. Using Appendix C and

looking for a table value of .625 ($5/$8), the annual growth rate is approximately ten
percent.

a. Cost of internal common stock (kcs):

 D1 
kcs =   + g
 Pcs 

$4(1 +.10 ) $4.40

= + .10 = + .10
$58 $58

= .1759 = 17.59%

b. Cost of external common (new common) stock, kncs

 D1 
kncs =   + g
 NPcs 

$4.40
= $58 (1 −0.08 )
+ .10

$4.40
= + .10
$53 .36

= .1825 = 18.25%
12-10A.

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 10 $140 $1,000
a. Price (Pd) = ∑ t +
t =1 (1 + 0.09) (1 + 0.09 )10

= $140(6.418) + $1000(.422)

= $1,320.52

b. NPd = $1,320.52(1 - 0.105)

= $1,181.87

$500 ,000
c. Number of Bonds = = 423.06 ≈ 424 Bonds
$1,181 .87

d. Cost of debt:

10 $140 $1,000
$1,181.87 = ∑ t +
t =1 (1 + k d ) (1 + k d )10

Rate Value Value

For 10% $1,246.30 $1,246.30
kd% 1,181.87
11% ________ 1,176.46
$ 64.43 $ 69.84

0.10 + 
$64 .43 
kd =   ×(0.01 ) = .1092 = 10.92%
 $69 .84 

After tax
cost of debt = 10.92%(1 - 0.34) = 7.21%
12-11A.
10 $100 $1,000
a. 1. Price (Pd) = ∑ +
t =1 (1 + 0.09) t (1 + 0.09 )10

= $100 (6.418) + $1,000 (.422)

= $1,063.80

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 2. NPd = $1,063.80 (1 - 0.105)

= $952.10

$500 ,000
3. Number of Bonds =
$952 .10

= 525.15 ≈ 526 Bonds

4. Cost of debt:

10 $100 $1,000
$952.10 = ∑ +
t =1 (1 + k d ) t (1 + k d )10

Rate Value Value

For: 10% $1,000.00 $1,000.00
kd% 952.10
11% ________ 940.90
$ 47.90 $ 59.10

0.10 + 
$47 .90 
kd =   × (0.01 ) = .1081 = 10.81%
 $59 .10 

After tax
cost of debt = 10.81%(1 - 0.34) = 7.13%

b. There is a very slight decrease in the cost of debt because the flotation costs
associated with the higher coupon bond are higher ($138.65 in flotation
costs for the 14 percent coupon bond versus $111.70 for the 10 percent
coupon bond).

12-12A.

Source Capital Structure After-tax cost of capital Weighted cost

Common Stock 40% 18% 7.2%
Preferred Stock 10% 10% 1.0%
Debt 50% 8% x (1-.35) 2.6%
kwacc = 10.8%

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12-13A.
Net price after flotation costs = $975 - $15

= $960.00

Cost of debt:
15
$60 $1,000
$960.00 = ∑
t =1 (1 + k d ) t
+
(1 + k d )15

Rate Value Value

For: 6% $1,000.00 $1,000.00
kd% 960.00
7% ________ 908.48
$ 40.00 $ 91.52

0.06 + 
$40 .00 
kd =   × (0.01 ) = .064 = 6.4%
 $91 .52 

After tax
cost of debt = 6.4%(1 - 0.30) = 4.48%

Cost of common stock, kncs

 D1 
kncs =   + g
 NPcs 

$2.25
= $30 (1 −0.05 )
+ .05

= .129 = 12.9%

Source Capital Structure After-tax cost of capital Weighted cost

Debt 60% 4.48% 2.69%
Common Stock 40% 12.9% 5.16%
kwacc = 7.85%

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12-14A.
Net price after flotation costs = $1,050 (1-.04)
= $1,008.00
Cost of debt:
10
$70 $1,000
$1,008.00 = ∑t =1 (1 + k d ) t
+
(1 + k d )10

Rate Value Value

For: 6% $1,096.84 $1,096.84
kd% 1,008.00
7% ________ 1,000.00
$ 88.84 $ 96.84

0.06 + 
$88 .84 
kd =   × (0.01 ) = .069 = 6.9%
 $96 .84 
After tax
cost of debt = 6.9 %(1 - 0.30) = 4.8%

Cost of preferred stock (kps)

Dividend D
kps = = NP
Net Price ps

$2.00 $2
= =
$25 −$3 $22
= .091 = 9.1%

Cost of common stock, kncs

 D1 
kncs =   + g
 NPcs 

$3(1 +.10 )
= + .10
$55 −$5

= .166 = 16.6%

Source Market Value Weight After-tax cost of capital Weighted Cost

Bonds $4,000,000 .33 4.8% 1.6%
Preferred Stock 2,000,000 .17 9.1% 1.5%
Common Stock 6,000,000 .50 16.6% 8.3%
12,000,000 1.00 kwacc = 11.4%

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