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CHAPTER 13

 

THE COST OF CAPITAL

 

 

FOCUS

     The cost of capital was introduced in Chapter 10 as an underpinning for capital budgeting, so the student is already familiar with the basic concept.  Here we focus on the practical intricacies of the calculation and the importance of using market values.

 

PEDAGOGY

     The cost of capital is a "big" calculation.  Many students have trouble wrapping their arms around it.  It's therefore important to develop an overview of the whole idea before getting lost in the calculations.  In other words, it’s a good idea to spend some time talking about the cost of capital as an “average rate” the company pays for the use of its long-term money, and why knowing the cost of capital is important.

 

TEACHING OBJECTIVES

     After studying this chapter, the student should appreciate the details of the weighted average cost of

capital concept, be able to calculate component capital costs, and develop the WACC as well as an MCC schedule.

 

OUTLINE

 

I.    THE PURPOSE OF THE COST OF CAPITAL

      The cost of capital as a benchmark for evaluating capital budgeting projects and as the firm's     required rate of return.

 

II.   COST OF CAPITAL CONCEPTS 

      A.  Capital Components

            Debt, Equity, and Preferred Stock.

      B.   Capital Structure 

            Structure as a mix of components.  The target structure and the proportions in which money is               raised.

      C.   Returns on Investments and the Costs of Capital Components

            The conceptual relationship between the return an investor receives and the cost of a                              component.

      D.  The Weighted Average Calculation - the WACC

            A preview of the weighted average idea and how it works.

      E.   Capital Structure and Cost - Book Versus Market Values

            The idea that structure and cost can be based on either book or market values and an                              explanation of  why market values are preferred.

 

III. CALCULATING THE WACC

      A. Developing Market-Value-Based Capital Structures

            How to develop a structure based on the current prices of the underlying securities.

      B.   Calculating Component Costs of Capital

            Adjusting returns for taxes and flotation cost to arrive at component costs.

      C.   Putting the Weights and Costs Together 

 

IV. THE MARGINAL COST OF CAPITAL (MCC)

      A.  The Break in MCC When Retained Earnings Run Out

            Defining the breakpoint and calculating its position.

      B.   The MCC Schedule

            Defining the MCC schedule and its use

V.  THE COST OF CAPITAL - A COMPREHENSIVE EXAMPLE

      A detailed example illustrating the calculation of the WACC and MCC.

 

VI. A POTENTIAL MISTAKE - HANDLING SEPARATELY FUNDED PROJECTS

      The fallacy of evaluating a project that comes with its own debt financing on the basis of the cost of      that financing rather than the WACC.

 

QUESTIONS

 

1.         Compare the cost of capital concept with the idea of the required return on a stock investment made by an individual.  Relate both ideas to the risk of the investment.  How would a very risky investment/ project be handled in the capital budgeting/cost of capital context? 

 

ANSWER: An individual won't invest in a stock unless its expected return exceeds his or her required return.  Similarly, a company won't invest in a project unless its expected return, traditionally called the IRR, exceeds the firm's cost of capital.  Hence the cost of capital functions exactly like a required return with respect to business investments.  In fact, the terms can be used interchangeably.

     Investors’ required returns increase with the risk of the investment being considered (remember the SML).  The cost of capital, however, is the same regardless of the investment being evaluated.  In this regard the concepts are different. 

     Therefore it doesn't make sense to evaluate high-risk projects with the cost of capital.  A rate adjusted upward for risk is more appropriate.

 

2.         Define the idea of capital structure and capital components.  Why is capital structure important to the cost of capital concept?  In many capital structure discussions, preferred stock is lumped in with either debt or common equity.  With respect to the cost of capital, however, it's treated separately.  Why?

 

ANSWER:  Capital components are the sources of capital, generally debt, equity and preferred stock.  Capital structure is the mix in which capital components are used. It is important to the cost of capital, because it provides the proportions in which we mix component costs to arrive at an overall cost of capital.  Preferred is treated separately because it generally has a cost that's different from either the cost of debt or the cost of equity.

 

3.         You are a new financial analyst working for a company that's more than 100 years old.  The CFO has asked you and a young member of the accounting staff to work together in reviewing the firm's capital structure for the purpose of recalculating its cost of capital.  As you both leave the CFO's office, your accounting colleague says that this job is really going to be easy, because he already has the information.  In preparing the latest annual report, he worked on the capital section of the balance sheet, and has the values of debt, preferred stock, and equity at his fingertips.  He says that the two of you can summarize these into a report in five minutes, and then go out for a beer.  How do you react and why?  Is the fact that the firm is quite old relevant?  Why?

 

ANSWER: You should politely tell your colleague that using book values of debt and equity will result in a cost of capital that reflects past conditions.  Since the cost of capital will be used to evaluate new projects, a figure that reflects current capital markets is more appropriate.  This is obtainable by using market values for capital structure.

     The fact that the firm is old makes it likely that book values will be very different from market values.  Hence, it makes a book approach even more undesirable. 

 

4.         The investor's return and the company's cost are opposite sides of the same coin—almost, but not quite.  Explain.

 

ANSWER:  The money paid to investors is the company's cost.  However, certain third parties are involved that make the amounts paid and received different.  Flotation costs are paid to investment bankers, so companies receive less than investors pay for securities.  That makes the companies' costs higher than the investors' returns.  Interest is tax deductible, so the government essentially contributes part of a company's interest payment to lenders.  That makes the cost of debt lower than the investor's return.

 

5.         There's an issue of historical versus market value with respect to both the cost of capital components and the amounts of those components used in developing weights.  We're willing to accept an approximation for the weights, but not for the cost/returns.  Why?

 

ANSWER:  We never raise money in the exact proportions of the capital structure, so any set of weights is an approximation of what's likely to happen when the firm actually issues securities.  Component costs, however, are close estimates of what will actually be encountered in the market.  Since those costs can vary considerably, it pays to use the latest estimates of market conditions.

     There is, however, an inconsistency in all this.  The cost of capital is not a precise calculation, so expending a great deal of effort on excessive accuracy in any one part is futile.

 

6.         A number of investment projects are under consideration at your company.  You've calculated the cost of capital based on market values and rates, and analyzed the projects using IRR and NPV.  Several projects are marginally acceptable.  While watching the news last night you learned that most economists predict a rise in interest rates over the next year.  Should you modify your analysis in light of this information?  Why? 

 

ANSWER: Yes.  Since rates are expected to rise, capital over the next year will probably be more expensive than capital raised today would be.  That means your cost of capital is probably understated.  If some projects are marginal, they would probably be unacceptable at the coming rates.  You should recalculate your cost of capital based on expected rates and rework your analysis.  Then show the decision makers both sets of figures explaining your reasoning.  They may or may not agree with the economists.

 

7.         Establishing the cost of equity is the most arbitrary and difficult part of developing a firm's cost of capital.  Outline the reasons behind this problem and the approaches available to making the best of it. 

 

ANSWER:  The cost of equity is related to the return on an investment in the firm's stock.  That return depends on dividends and price movements which can only be estimated.  The return on bonds and preferred stock is exact, because interest and principal payments and preferred dividends are specified in the contracts with investors.

     Because of this inaccuracy, we estimate the cost of equity based on projected growth rates and risk.  The growth rate approach uses the Gordon model.  There are two risk approaches.  One uses the CAPM while the other adds a risk premium to the return the firm pays on its debt.

 

8.         Retained earnings are generated by the firm's internal operations and are immediately reinvested to earn more money for the company and its shareholders.  Therefore, such funds have zero cost to the company.  Is that statement true or false?  Explain.

 

ANSWER: False.  Retained earnings belong to stockholders and have been reinvested for them without their explicit permission.  Stockholders are therefore entitled to the same return on those equity funds that they receive on the price paid for stock.  The cost of retained earnings, therefore, is the same as the cost of equity received from the sale of stock except for the absence of flotation costs.

 

9.         Define the marginal cost of capital (MCC) and explain in words why it predictably undergoes a step function increase (breaks) as more capital is raised during a budget period.

 

ANSWER:  The marginal cost of capital is the cost of the next dollar raised.  As more money is raised during a single period, investors become concerned about risk and demand higher returns.  As required returns increase, so does the cost of capital components and the WACC. 

     The first increase generally occurs before risk is a factor.  When the firm exhausts currently retained earnings, it must obtain new equity by selling stock.  But selling stock involves flotation cost, which makes it more expensive than retained earnings.

 

10.       After the break in the MCC caused by using up retained earnings, the schedule can be expected to remain flat indefinitely.  Is this statement right or wrong?  If wrong, explain what can be expected to happen to the MCC and why.

 

ANSWER:  The statement is incorrect.  As more money is raised during a single period, investors become concerned about risk and demand higher returns.  As required returns increase, so does the cost of capital components and the WACC.  This implies that the MCC will experience step function increases as more money is raised.

 

11.       Why is it appropriate to define the WACC as the highest step on the MCC under the IOS?  Is anything lost by using this definition?

 

ANSWER:  If the WACC is defined as the highest step on the MCC under the IOS, we don't have to worry about changing it as more money is raised.  Since projects are generally considered in descending order of IRR, using the highest WACC will not reject anything to the left of the intersection, so nothing is lost by using that one rate throughout.

 

 

BUSINESS ANALYSIS

 

1.         You're the newly hired CFO of a small construction company.  The privately held firm is capitalized with $2 million in owner's equity and $3 million in variable rate bank loans.  The construction business is quite risky, so returns of 20% to 25% are normally demanded on equity investments.  The bank is currently charging 14% on the firm's loans, but interest rates are expected to rise in the near future.  Your boss, the owner, started his career as a carpenter and has an excellent grasp of day-to-day operations.  However, he knows little about finance.  Business has been good lately, and several expansion projects are under consideration.  A cash flow projection has been made for each.  You're satisfied that these estimates are reasonable. 

     The owner has called you in and confessed to being confused about the projects.  He instinctively feels that some are financially marginal and may not be beneficial to the company, but he doesn't know how to demonstrate this or to choose among the projects that are financially viable.

     Assuming the owner understands the concept of return on investment, write a brief memo explaining the ideas of IRR and cost of capital and how they can solve his problem.  Don't get into the detailed mechanics of the calculations, but do use the figures given above to make a rough estimate of the company's cost of capital, and use the result in your memo. 

 

ANSWER:  Every business has to pay for the funds it uses.  We call that payment the cost of the funds and generally express it as a percentage like an interest rate.  Long-term money, comes from debt and equity, and the cost of each is closely related to the returns the firm pays those investors. 

     When a firm considers projects that use long-term money, it's appropriate to estimate its cost in a pooled sense.  When we do that we call the money capital and develop a single cost figure for it.  Under this logic, the overall cost of capital, is an average of the costs of debt and equity where the average is weighted by the amounts of debt and equity in use. 

     In our case, the company is financed with a mix that's about 40% equity and 60% debt.  The cost of equity is about 20% while the after tax cost of debt is in the neighborhood of 9%.  That means our overall cost of capital is between 13% and 14%. Once we know what our money costs, it's apparent

that we should never use it in a venture that returns less than that cost.

     Now let's turn to projects for a moment.  They earn returns on invested funds called "Internal Rates of Return (IRRs)".  For example, the IRR on just putting money in the bank is the interest rate the bank pays.

     Choosing among projects is conceptually simple.  If risks are about the same, we choose projects with the highest IRRs.  But it never makes sense to undertake a project that doesn't earn at least as much as the cost of funds put into it.  To do that would be to plan to lose money!  For example, it wouldn't make much sense to put company money in a savings account paying 5%, because the money costs us 14%.

     Now put the ideas of cost of capital and IRR together.  The projects we're considering all have calculated IRRs.  Anything with an IRR below 14% isn't a good idea, because that's less than what we pay for the money we'll put into it. Projects with IRRs between 14% and about 16% are pretty marginal.  Those with higher IRRs may be ok if the cash projections are reasonable and the risks aren't out of line.

 

2.         You're the CFO of a small company that is considering a new venture.  The president and several other members of management are very excited about the idea for reasons related to engineering and marketing rather than profitability.  You've analyzed the proposal by using capital budgeting techniques, and found that it fails both IRR and NPV tests using a cost of capital based on market returns.  The problem is that interest rates have risen steeply in the last year, so the cost of capital seems unusually high. 

     You've presented your results to the management team, who are very disappointed.  In fact, they'd like to find a way to discredit your analysis, so they can justify going ahead with the project.  You've explained your analysis, and everything seems well understood except for one point.  The group insists that the use of returns currently available to investors as a basis for the cost of capital components doesn't make sense.  The vice president of marketing put his objection as follows.  "Two years ago we borrowed $1 million at 10%.  We haven't paid it back, and we're still making interest payments of $100,000 every year.  Clearly, our cost of debt is 10% and not the 14% you want to use.  If you'd use

our "real" cost of debt, as well as of equity and preferred stock, the project would easily qualify financially."  How do you respond? 

     (The appropriate response is relatively short.  It's worth noting that this kind of thing happens all the time in corporations.  Marketing and engineering people often get carried away with "neat" projects that don't make sense financially.  The CFO has to watch the bottom line and it's not unusual to be seen as a wet blanket who wants to spoil the others' fun!)

 

ANSWER:  We can't use the money we raised two years ago on this project, because it's already been spent.  We have to raise new capital for the new project.  You're right in that the cost of our existing capital is a much lower figure than the one I'm using.  But that fact is irrelevant.  What's important is the cost of the money we'll be raising in the near future to fund this project.  That cost is reflected by current market rates, which are much higher than our old rates.

 

3.         The engineering department at Digitech Inc. wants to buy a new, state-of-the-art computer.  The proposed machine is faster than the one now being used, but whether the extra speed is worth the expense is questionable, given the nature of the firm's applications.  The Chief Engineer (who has an MBA and a reasonable understanding of financial principles) has put together an enormously detailed capital budgeting proposal for the acquisition of the new machine.  The proposal concludes that it's a great deal. 

     You're a financial analyst for the firm, and have been assigned to review the engineering proposal.  Your review has highlighted two problems.  First, the cost savings projected as a result of using the new machine seem rather optimistic.  Second, the analysis uses an unrealistically low cost of capital. 

     With respect to the second point, the engineering proposal contains the following exhibit documenting the development of the cost of capital used:

 

 

Digitech's capital structure is 60% debt and 40% equity

 

The manufacturer is offering financing at 8% as a sales incentive

 

Cost of capital = 8% ´ .6 = 4.8%

 

After tax this is 4.8% (1-T) = 4.8%(.6) = 2.9%

 

 

            You've checked the market and found that Digitech's bonds are currently selling to yield 14% and the stock is returning about 20%.  How would you proceed?  That is, explain the chief engineer's error(s) and indicate the correct calculations.

 

ANSWER:  The chief engineer has really forgotten his finance!  The first mistake is using the cost of dedicated financing to evaluate a project instead of the cost of capital.  This is an incorrect procedure that leads to bad decisions in the long run although it will virtually assure acceptance of the current project. (See "A Potential Mistake - Handling Separately Funded Projects.")  On top of that, the proposal uses part of a weighted average calculation to further decrease the interest rate used to evaluate the project.

     This coupled with the optimistic cash flow estimates makes one think that the computer may be something the engineers want but can't really support financially.  That means it's likely to be an emotional issue.  It's probably best if you don't go to the chief engineer yourself to challenge his proposal.  Take your findings to the CFO and let her approach the chief engineer in private and work the matter out. 

     This situation illustrates something that's fairly common.  A proposal is presented with so much supporting information that it's difficult to find the errors and unrealistic assumptions buried in the details.

 

4.         Whitefish Inc. operates a fleet of 15 fishing boats in the North Atlantic Ocean.  Fishing has been good in the last few years, as has the market for product, so the firm can sell all the fish it can catch.  Charlie Bass, the vice president for operations, has worked up a capital budgeting proposal for the acquisition of new boats.  Each boat is viewed as an individual project identical to the others, and shows an IRR of 22%.  The firm's cost of capital has been correctly calculated at 14% before the retained earnings break and 15% after that point.  Charlie argues that the capital budgeting figures show that the firm should acquire as many new boats as it possibly can, financing them with whatever means it finds available.  You are Whitefish's CFO.  Support or criticize Charlie's position.  How should the appropriate number of new boats be determined?  Does acquiring a large number of new boats present any problems or risks that aren’t immediately apparent from the financial figures?

 

ANSWER:  Although the WACC is 15% after the retained earnings break, it won't remain at that level indefinitely.  As more boats are acquired with new financing, the cost of capital will rise and eventually exceed 22%.  The appropriate level of investment in new boats should be determined by investigating how the MCC will behave, and estimating where it will exceed 22%. 

     Charlie's estimate is based on current fishing and market conditions.  If those conditions aren't stable, buying a large number of new boats could increase the firm's risk substantially.

 

 

PROBLEMS

 

 

WACC Calculations: Example 13-1 (page 561)

1.         Blazingame Inc.'s capital components have the following market values:

 

     Debt                        $35,180,000

     Preferred Stock       $17,500,000

     Common Equity                 $48,350,000

Calculate the firm's capital structure and show the weights that would be used for a weighted average cost of capital (WACC) computation. 

 

SOLUTION:

                                    Values             Weights

   Debt                          $35,180           .348

   Preferred Stock         $17,500           .173

   Common Equity                   $48,350           .479

                                   $101,030           1.000

 

2.         The Aztec Corporation has the following capital components and costs.  Calculate Aztec's WACC.

 

Component                  Value               Cost

Debt                             $23,625           12.0%

Preferred Stock            $  4,350           13.5%

Common Equity          $52,275           19.2%

 

SOLUTION:

Component                  Value               Weights            Cost     Factors

Debt                             $23,625           .294                 12.0% 3.53

Preferred Stock            $  4,350           .054                 13.5%     .73

Common Equity          $52,275           .652*                           19.2%  12.52

                                    $80,250           1.000                                       16.78

                                                                        Use WACC   = 16.8%

 

     *Rounding sometimes causes the weights to sum to a figure slightly different from 1.000.  When that happens we generally round one figure the wrong way to show weights that add to exactly 1.000.

 

3.         Willerton Industries Inc. has the following balances in its capital accounts as of 12/31/x3:

 

            Long Term Debt                      $65,000,000

                        Preferred Stock                                    $15,000,000

            Common Stock                                    $40,000,000

                        Paid in Excess                          $15,000,000

            Retained Earnings                    $37,500,000

 

 

 

            Calculate Willerton’s capital structure based on book values.

 

SOLUTION ($M)

                                                                                 %

            Debt                                   $65.0                 37.7

            Preferred Stock                    15.0                   8.7

            Equity                                  92.5                 53.6

            Total                                $172.5               100.0

 

 

Market Value Based Capital Structure: Example 13-2 (page 564)

4.         Referring to Willerton Industries of the previous problem, the company’s long term debt is comprised of 20-year $1,000 face value bonds issued seven years ago at an 8% coupon rate.  The bonds are now selling to yield 6%.  Willerton’s preferred is from a single issue of $100 par value, 9% preferred stock that is now selling to yield 8%.  Willerton has four million shares of common stock outstanding at a current market price of $31.  Calculate Willerton’s market value based capital structure.

 

SOLUTION:

a.         Market value of debt:

            n = 13 x 2 = 26

            FV = 1,000

            I/Y = 6/2 = 3

            PMT = 1,000 x 8%/2 = 40

            PV = ? = 1,178.77

 

            Market value of preferred stock

            Number of preferred shares from previous problem

            $15M/$100 = 150,000

            $9/.08 = $112.50

 

            Total market values

     Market Value                                     %

            Debt  $1,178.77 x 65,000                        $76,620,050                                35.2

            Preferred stock $112.50 x 150,000           16,875,000                                  7.8

            Equity  $31 x 4,000,000                          124,000,000                                57.0

                                                                          $217,495,050                              100.0

 

 

5.         Again referring to Willerton of the two previous problems, assume the firm’s cost of retained earnings is 11% and its marginal tax rate is 40%, calculate its WACC using its book value based capital structure ignoring floatation costs.  Make the same calculation using the market value based capital structure.  How significant is the difference?

 

SOLUTION:

 

            Book Value

            Debt  .377 x 6.0% x (1 - .4)                           1.36

            Preferred  .087 x 8%                                       .70

            Equity  .536 x 11%                                        5.90

            WACC                                                           7.96%

 

            Market Value

            Debt  .352 x 6.0% x (1 - .4)                           1.27

            Preferred  .078 x 8%                                       .62

            Equity  .57 x 11%                                          6.27

            WACC                                                           8.16%

 

            In this case, WACCs based on book and market values are only 0.2% apart, a relatively insignificant difference.

 

 

6.         A relatively young firm has capital components valued at book and market and market component costs as follows.  No new securities have been issued since the firm was originally capitalized.

 

                                                Values                         Market

Component                  Market             Book                  Cost

Debt                             $42,830           $40,000           8.5%

Preferred Stock            $10,650           $10,000           10.6%

Common Equity          $65,740           $32,000           25.3%

 

 a. Calculate the firm's capital structures and WACCs based on both book and market values, and compare the two. 

 b. What appears to have happened to interest rates since the company was started? 

 c. Does the firm seem to be successful?  Why? 

 d. What would be the implication of using a WACC based on book as opposed to market values?  In other words, what kinds of mistakes might management make by using the book values?

 

SOLUTION:

a.                                                                                                                         Factors

                                    Market               Weights          Book    Weights            Costs                Market    Book

Debt                             $42,830     .359           $40,000    .488                        8.5%     3.05     4.15

Preferred Stock            $10,650     .090           $10,000    .122            10.6%                  .95     1.29

Common Equity          $65,740     .551           $32,000    .390            25.3%   13.94                 9.87

                                   $119,220   1.000          $82,000  1.000                        17.94     15.31

                                                                                                Use WACCs  = 17.9%    15.3%

 

Comparison: The overall cost of capital has risen due to the net impact of a large increase in the value of the firm's equity.  This throws more of equity's high cost into the WACC.

 

b.  Interest rates appear to have fallen, since the market values of debt and preferred exceed their original values.

 

c.  The firm seems to be successful because of the substantial increase in the value of equity.  This could be due to an increase in stock price or a rapid accumulation of retained earnings or a combination of both.

 

d.  Using the book based WACC might lead to accepting projects that wouldn't achieve the expectations investors have for the company's return.

 

7.         Five years ago Hemingway Inc. issued 6,000 thirty-year bonds with par values of $1,000 at a coupon rate of 8%.  The bonds are now selling to yield 5%.  The company also has 15,000 shares of preferred stock outstanding that pay a dividend of $6.50 per share.  These are currently selling to yield 10%.  Its common stock is selling at $21, and 200,000 shares are outstanding.  Calculate Hemingway’s market value based capital structure. 

 

SOLUTION:

            The current price of the bonds is

            PB = PMT[PVFAk,n] + FV[PVFk,n]

            PB = $40[PVFA2.5,50] + $1,000[PVF2.5,50]

            PB = $40[28.3623] + $1,000[.2909]

            PB = $1,134.49 + $290.90

            PB = $1,425.39

The market value of 6,000 bonds is

                                    $1,425.39 ´ 6,000 = $8,552,340

The preferred stock shares are each worth

                                    PP = $6.50 / .10 = $65.00

In total they’re worth

                                    $65.00 ´ 15,000 = $975,000

            The market value of the stock is simply

                                    $21.00 ´ 200,000 = $4,200,000

            Total capital is the sum of these figures and capital structure is each component divided by the total stated as a percent.

 

                        Component                         Value                       Capital Structure

                           Debt                          $  8,552,340                              62.3%

                           Preferred                          975,000                                7.1%

                           Equity                           4,200,000                              30.6%

                            Total Capital                        $13,727,340                            100.0%

 

 

8.         The Wall Company has 142,500 shares of common stock outstanding that are currently selling at $28.63.  It has 4,530 bonds outstanding that won’t mature for 20 years.  They were issued at a par value of $1,000 paying a coupon rate of 6%.  Comparable bonds now yield 9%.  Wall’s $100 par value preferred stock was issued at 8% and is now yielding 11%; 7,500 shares are outstanding.  Develop Wall’s market value based capital structure. 

 

SOLUTION:

            The current price of the bonds is

            PB = PMT[PVFAk,n] + FV[PVFk,n]

            PB = $30[PVFA4.5,40] + $1,000[PVF4.5,40]

            PB = $30[18.4016] + $1,000[.1719]

            PB = $552.05 + $171.90

            PB = $723.95

The market value of 4,530 bonds is

                                    $723.95 ´ 4,530 = $3,279,494

The preferred stock shares pay a dividend of ($100x.08=) $8.00, and are each worth

                                    PP = $8.00 / .11 = $72.73

In total they’re worth

                                    $72.73 ´ 7,500 = $545,475

            The market value of the common stock is 

                                    $28.63 ´ 142,500 = $4,079,775

            Total capital is the sum of these figures and capital structure is each component divided by the total stated as a percent.

 

                        Component                      Value                          Capital Structure

                           Debt                          $3,279,494                                41.5%

                           Preferred                        545,475                                  6.9%

                           Equity                         4,079,775                                51.6%

                            Total Capital                        $7,904,744                              100.0%

 

 

9.         The market price of Albertson Ltd.’s common stock is $5.50, and 100,000 shares are outstanding.  The firm's books show common equity accounts totaling $400,000.  There are 5,000 preferred shares outstanding that originally sold for their par value of $50, pay an annual dividend of $3, and are currently selling to yield an 8% return.  Also, 200 bonds outstanding that were issued five years ago at their $1,000 face values for 30-year terms pay a coupon rate of 7%, and are currently selling to yield 10%.  Develop Albertson's capital structure based on both book and market values. 

 

SOLUTION: Views (475)

Body Preview(10747 words)

CHAPTER xxxxxxx align="center"> 

THE xxxxxxx OF CAPITAL

 

 

FOCUS

     xxxxxxx xxxxxxx of xxxxxxx was introduced xxxxxxx Chapter 10 xxxxxxx an xxxxxxx xxxxxxx capital budgeting, xxxxxxx the student xxxxxxx already familiar xxxxxxx the basic xxxxxxx Here we xxxxxxx on the xxxxxxx xxxxxxx of xxxxxxx calculation and xxxxxxx importance of xxxxxxx market xxxxxxx xxxxxxx cost of xxxxxxx is a xxxxxxx calculation.  Many xxxxxxx have trouble xxxxxxx their arms xxxxxxx it.  It's xxxxxxx xxxxxxx to xxxxxxx an overview xxxxxxx the whole xxxxxxx before xxxxxxx xxxxxxx in the xxxxxxx In other xxxxxxx it’s a xxxxxxx idea to xxxxxxx some time xxxxxxx about the xxxxxxx xxxxxxx capital xxxxxxx an “average xxxxxxx the company xxxxxxx for xxxxxxx xxxxxxx of its xxxxxxx money, and xxxxxxx knowing the xxxxxxx of capital xxxxxxx important.

 

TEACHING OBJECTIVES

     xxxxxxx studying this xxxxxxx xxxxxxx student xxxxxxx appreciate the xxxxxxx of the xxxxxxx average xxxxxxx xxxxxxx concept, be xxxxxxx to calculate xxxxxxx capital costs, xxxxxxx develop the xxxxxxx as well xxxxxxx an MCC xxxxxxx xxxxxxx PURPOSE xxxxxxx THE COST xxxxxxx CAPITAL

      The xxxxxxx of xxxxxxx xxxxxxx a benchmark xxxxxxx evaluating capital xxxxxxx projects and xxxxxxx the firm's xxxxxxx required rate xxxxxxx return.

 

II.   COST xxxxxxx xxxxxxx CONCEPTS 

      xxxxxxx Capital Components

            xxxxxxx Equity, and xxxxxxx Stock.

      xxxxxxx xxxxxxx Structure 

            Structure xxxxxxx a mix xxxxxxx components.  The xxxxxxx structure and xxxxxxx proportions in xxxxxxx money is xxxxxxx xxxxxxx raised.

      xxxxxxx Returns on xxxxxxx and the xxxxxxx of xxxxxxx xxxxxxx The conceptual xxxxxxx between the xxxxxxx an investor xxxxxxx and the xxxxxxx of a xxxxxxx       component.

      xxxxxxx xxxxxxx Weighted xxxxxxx Calculation - xxxxxxx WACC

            A xxxxxxx of xxxxxxx xxxxxxx average idea xxxxxxx how it xxxxxxx E.   Capital xxxxxxx and Cost xxxxxxx Book Versus xxxxxxx Values

            The xxxxxxx xxxxxxx structure xxxxxxx cost can xxxxxxx based on xxxxxxx book xxxxxxx xxxxxxx values and xxxxxxx                              xxxxxxx of  why xxxxxxx values are xxxxxxx CALCULATING THE xxxxxxx A. Developing xxxxxxx xxxxxxx Structures

            xxxxxxx to develop xxxxxxx structure based xxxxxxx the xxxxxxx xxxxxxx of the xxxxxxx securities.

      B.   xxxxxxx Component Costs xxxxxxx Capital

            Adjusting xxxxxxx for taxes xxxxxxx flotation cost xxxxxxx xxxxxxx at xxxxxxx costs.

      C.   xxxxxxx the Weights xxxxxxx Costs xxxxxxx xxxxxxx MARGINAL COST xxxxxxx CAPITAL (MCC)

      xxxxxxx The Break xxxxxxx MCC When xxxxxxx Earnings Run xxxxxxx Defining the xxxxxxx xxxxxxx calculating xxxxxxx position.

      B.   xxxxxxx MCC Schedule

            xxxxxxx the xxxxxxx xxxxxxx and its xxxxxxx THE COST xxxxxxx CAPITAL - xxxxxxx COMPREHENSIVE EXAMPLE

      xxxxxxx detailed example xxxxxxx the calculation xxxxxxx xxxxxxx WACC xxxxxxx MCC.

 

VI. A xxxxxxx MISTAKE - xxxxxxx SEPARATELY xxxxxxx xxxxxxx The fallacy xxxxxxx evaluating a xxxxxxx that comes xxxxxxx its own xxxxxxx financing on xxxxxxx basis of xxxxxxx xxxxxxx of xxxxxxx that financing xxxxxxx than the xxxxxxx Compare xxxxxxx xxxxxxx of capital xxxxxxx with the xxxxxxx of the xxxxxxx return on xxxxxxx stock investment xxxxxxx by an xxxxxxx xxxxxxx both xxxxxxx to the xxxxxxx of the xxxxxxx How xxxxxxx xxxxxxx very risky xxxxxxx project be xxxxxxx in the xxxxxxx budgeting/cost of xxxxxxx context? 

 

ANSWER: An xxxxxxx won't invest xxxxxxx xxxxxxx stock xxxxxxx its expected xxxxxxx exceeds his xxxxxxx her xxxxxxx xxxxxxx Similarly, a xxxxxxx won't invest xxxxxxx a project xxxxxxx its expected xxxxxxx traditionally called xxxxxxx IRR, exceeds xxxxxxx xxxxxxx cost xxxxxxx capital.  Hence xxxxxxx cost of xxxxxxx functions xxxxxxx xxxxxxx a required xxxxxxx with respect xxxxxxx business investments.  xxxxxxx fact, the xxxxxxx can be xxxxxxx interchangeably.

     Investors’ xxxxxxx xxxxxxx increase xxxxxxx the risk xxxxxxx the investment xxxxxxx considered xxxxxxx xxxxxxx SML).  The xxxxxxx of capital, xxxxxxx is the xxxxxxx regardless of xxxxxxx investment being xxxxxxx In this xxxxxxx xxxxxxx concepts xxxxxxx different. 

     Therefore xxxxxxx doesn't make xxxxxxx to xxxxxxx xxxxxxx projects with xxxxxxx cost of xxxxxxx A rate xxxxxxx upward for xxxxxxx is more xxxxxxx Define the xxxxxxx xxxxxxx capital xxxxxxx and capital xxxxxxx Why is xxxxxxx structure xxxxxxx xxxxxxx the cost xxxxxxx capital concept?  xxxxxxx many capital xxxxxxx discussions, preferred xxxxxxx is lumped xxxxxxx with either xxxxxxx xxxxxxx common xxxxxxx With respect xxxxxxx the cost xxxxxxx capital, xxxxxxx xxxxxxx treated separately.  xxxxxxx  Capital components xxxxxxx the sources xxxxxxx capital, generally xxxxxxx equity and xxxxxxx stock.  Capital xxxxxxx xxxxxxx the xxxxxxx in which xxxxxxx components are xxxxxxx It xxxxxxx xxxxxxx to the xxxxxxx of capital, xxxxxxx it provides xxxxxxx proportions in xxxxxxx we mix xxxxxxx costs to xxxxxxx xxxxxxx an xxxxxxx cost of xxxxxxx Preferred is xxxxxxx separately xxxxxxx xxxxxxx generally has xxxxxxx cost that's xxxxxxx from either xxxxxxx cost of xxxxxxx or the xxxxxxx of equity.

 

3.         xxxxxxx xxxxxxx a xxxxxxx financial analyst xxxxxxx for a xxxxxxx that's xxxxxxx xxxxxxx 100 years xxxxxxx The CFO xxxxxxx asked you xxxxxxx a young xxxxxxx of the xxxxxxx staff to xxxxxxx xxxxxxx in xxxxxxx the firm's xxxxxxx structure for xxxxxxx purpose xxxxxxx xxxxxxx its cost xxxxxxx capital.  As xxxxxxx both leave xxxxxxx CFO's office, xxxxxxx accounting colleague xxxxxxx that this xxxxxxx xxxxxxx really xxxxxxx to be xxxxxxx because he xxxxxxx has xxxxxxx xxxxxxx In preparing xxxxxxx latest annual xxxxxxx he worked xxxxxxx the capital xxxxxxx of the xxxxxxx sheet, and xxxxxxx xxxxxxx values xxxxxxx debt, preferred xxxxxxx and equity xxxxxxx his xxxxxxx xxxxxxx says that xxxxxxx two of xxxxxxx can summarize xxxxxxx into a xxxxxxx in five xxxxxxx and then xxxxxxx xxxxxxx for xxxxxxx beer.  How xxxxxxx you react xxxxxxx why?  xxxxxxx xxxxxxx fact that xxxxxxx firm is xxxxxxx old relevant?  xxxxxxx You should xxxxxxx tell your xxxxxxx that using xxxxxxx xxxxxxx of xxxxxxx and equity xxxxxxx result in xxxxxxx cost xxxxxxx xxxxxxx that reflects xxxxxxx conditions.  Since xxxxxxx cost of xxxxxxx will be xxxxxxx to evaluate xxxxxxx projects, a xxxxxxx xxxxxxx reflects xxxxxxx capital markets xxxxxxx more appropriate.  xxxxxxx is xxxxxxx xxxxxxx using market xxxxxxx for capital xxxxxxx The fact xxxxxxx the firm xxxxxxx old makes xxxxxxx likely that xxxxxxx xxxxxxx will xxxxxxx very different xxxxxxx market values.  xxxxxxx it xxxxxxx xxxxxxx book approach xxxxxxx more undesirable. 

 

4.         xxxxxxx investor's return xxxxxxx the company's xxxxxxx are opposite xxxxxxx of the xxxxxxx xxxxxxx but xxxxxxx quite.  Explain.

 

ANSWER:  xxxxxxx money paid xxxxxxx investors xxxxxxx xxxxxxx company's cost.  xxxxxxx certain third xxxxxxx are involved xxxxxxx make the xxxxxxx paid and xxxxxxx different.  Flotation xxxxxxx xxxxxxx paid xxxxxxx investment bankers, xxxxxxx companies receive xxxxxxx than xxxxxxx xxxxxxx for securities.  xxxxxxx makes the xxxxxxx costs higher xxxxxxx the investors' xxxxxxx Interest is xxxxxxx deductible, so xxxxxxx xxxxxxx essentially xxxxxxx part of xxxxxxx company's interest xxxxxxx to xxxxxxx xxxxxxx makes the xxxxxxx of debt xxxxxxx than the xxxxxxx return.

 

5.         There's xxxxxxx issue of xxxxxxx versus market xxxxxxx xxxxxxx respect xxxxxxx both the xxxxxxx of capital xxxxxxx and xxxxxxx xxxxxxx of those xxxxxxx used in xxxxxxx weights.  We're xxxxxxx to accept xxxxxxx approximation for xxxxxxx weights, but xxxxxxx xxxxxxx the xxxxxxx Why?

 

ANSWER:  We xxxxxxx raise money xxxxxxx the xxxxxxx xxxxxxx of the xxxxxxx structure, so xxxxxxx set of xxxxxxx is an xxxxxxx of what's xxxxxxx to happen xxxxxxx xxxxxxx firm xxxxxxx issues securities.  xxxxxxx costs, however, xxxxxxx close xxxxxxx xxxxxxx what will xxxxxxx be encountered xxxxxxx the market.  xxxxxxx those costs xxxxxxx vary considerably, xxxxxxx pays to xxxxxxx xxxxxxx latest xxxxxxx of market xxxxxxx There is, xxxxxxx an xxxxxxx xxxxxxx all this.  xxxxxxx cost of xxxxxxx is not xxxxxxx precise calculation, xxxxxxx expending a xxxxxxx deal of xxxxxxx xxxxxxx excessive xxxxxxx in any xxxxxxx part is xxxxxxx A xxxxxxx xxxxxxx investment projects xxxxxxx under consideration xxxxxxx your company.  xxxxxxx calculated the xxxxxxx of capital xxxxxxx on market xxxxxxx xxxxxxx rates, xxxxxxx analyzed the xxxxxxx using IRR xxxxxxx NPV.  xxxxxxx xxxxxxx are marginally xxxxxxx While watching xxxxxxx news last xxxxxxx you learned xxxxxxx most economists xxxxxxx a rise xxxxxxx xxxxxxx rates xxxxxxx the next xxxxxxx Should you xxxxxxx your xxxxxxx xxxxxxx light of xxxxxxx information?  Why? 

 

ANSWER: xxxxxxx Since rates xxxxxxx expected to xxxxxxx capital over xxxxxxx next year xxxxxxx xxxxxxx be xxxxxxx expensive than xxxxxxx raised today xxxxxxx be.  xxxxxxx xxxxxxx your cost xxxxxxx capital is xxxxxxx understated.  If xxxxxxx projects are xxxxxxx they would xxxxxxx be unacceptable xxxxxxx xxxxxxx coming xxxxxxx You should xxxxxxx your cost xxxxxxx capital xxxxxxx xxxxxxx expected rates xxxxxxx rework your xxxxxxx  Then show xxxxxxx decision makers xxxxxxx sets of xxxxxxx explaining your xxxxxxx xxxxxxx may xxxxxxx may not xxxxxxx with the xxxxxxx Establishing xxxxxxx xxxxxxx of equity xxxxxxx the most xxxxxxx and difficult xxxxxxx of developing xxxxxxx firm's cost xxxxxxx capital.  Outline xxxxxxx xxxxxxx behind xxxxxxx problem and xxxxxxx approaches available xxxxxxx making xxxxxxx xxxxxxx of it. 

 

ANSWER:  xxxxxxx cost of xxxxxxx is related xxxxxxx the return xxxxxxx an investment xxxxxxx the firm's xxxxxxx xxxxxxx return xxxxxxx on dividends xxxxxxx price movements xxxxxxx can xxxxxxx xxxxxxx estimated.  The xxxxxxx on bonds xxxxxxx preferred stock xxxxxxx exact, because xxxxxxx and principal xxxxxxx and preferred xxxxxxx xxxxxxx specified xxxxxxx the contracts xxxxxxx investors.

     Because xxxxxxx this xxxxxxx xxxxxxx estimate the xxxxxxx of equity xxxxxxx on projected xxxxxxx rates and xxxxxxx The growth xxxxxxx approach uses xxxxxxx xxxxxxx model.  xxxxxxx are two xxxxxxx approaches.  One xxxxxxx the xxxxxxx xxxxxxx the other xxxxxxx a risk xxxxxxx to the xxxxxxx the firm xxxxxxx on its xxxxxxx Retained earnings xxxxxxx xxxxxxx by xxxxxxx firm's internal xxxxxxx and are xxxxxxx reinvested xxxxxxx xxxxxxx more money xxxxxxx the company xxxxxxx its shareholders.  xxxxxxx such funds xxxxxxx zero cost xxxxxxx the company.  xxxxxxx xxxxxxx statement xxxxxxx or false?  xxxxxxx False.  Retained xxxxxxx belong xxxxxxx xxxxxxx and have xxxxxxx reinvested for xxxxxxx without their xxxxxxx permission.  Stockholders xxxxxxx therefore entitled xxxxxxx the same xxxxxxx xxxxxxx those xxxxxxx funds that xxxxxxx receive on xxxxxxx price xxxxxxx xxxxxxx stock.  The xxxxxxx of retained xxxxxxx therefore, is xxxxxxx same as xxxxxxx cost of xxxxxxx received from xxxxxxx xxxxxxx of xxxxxxx except for xxxxxxx absence of xxxxxxx costs.

 

9.         xxxxxxx xxxxxxx marginal cost xxxxxxx capital (MCC) xxxxxxx explain in xxxxxxx why it xxxxxxx undergoes a xxxxxxx function increase xxxxxxx xxxxxxx more xxxxxxx is raised xxxxxxx a budget xxxxxxx The xxxxxxx xxxxxxx of capital xxxxxxx the cost xxxxxxx the next xxxxxxx raised.  As xxxxxxx money is xxxxxxx during a xxxxxxx xxxxxxx investors xxxxxxx concerned about xxxxxxx and demand xxxxxxx returns.  xxxxxxx xxxxxxx returns increase, xxxxxxx does the xxxxxxx of capital xxxxxxx and the xxxxxxx The first xxxxxxx generally occurs xxxxxxx xxxxxxx is xxxxxxx factor.  When xxxxxxx firm exhausts xxxxxxx retained xxxxxxx xxxxxxx must obtain xxxxxxx equity by xxxxxxx stock.  But xxxxxxx stock involves xxxxxxx cost, which xxxxxxx it more xxxxxxx xxxxxxx retained xxxxxxx After the xxxxxxx in the xxxxxxx caused xxxxxxx xxxxxxx up retained xxxxxxx the schedule xxxxxxx be expected xxxxxxx remain flat xxxxxxx Is this xxxxxxx right or xxxxxxx xxxxxxx wrong, xxxxxxx what can xxxxxxx expected to xxxxxxx to xxxxxxx xxxxxxx and why.

 

ANSWER:  xxxxxxx statement is xxxxxxx As more xxxxxxx is raised xxxxxxx a single xxxxxxx investors become xxxxxxx xxxxxxx risk xxxxxxx demand higher xxxxxxx As required xxxxxxx increase, xxxxxxx xxxxxxx the cost xxxxxxx capital components xxxxxxx the WACC.  xxxxxxx implies that xxxxxxx MCC will xxxxxxx step function xxxxxxx xxxxxxx more xxxxxxx is raised.

 

11.       xxxxxxx is it xxxxxxx to xxxxxxx xxxxxxx WACC as xxxxxxx highest step xxxxxxx the MCC xxxxxxx the IOS?  xxxxxxx anything lost xxxxxxx using this xxxxxxx xxxxxxx the xxxxxxx is defined xxxxxxx the highest xxxxxxx on xxxxxxx xxxxxxx under the xxxxxxx we don't xxxxxxx to worry xxxxxxx changing it xxxxxxx more money xxxxxxx raised.  Since xxxxxxx xxxxxxx generally xxxxxxx in descending xxxxxxx of IRR, xxxxxxx the xxxxxxx xxxxxxx will not xxxxxxx anything to xxxxxxx left of xxxxxxx intersection, so xxxxxxx is lost xxxxxxx using that xxxxxxx xxxxxxx throughout.

 

 

BUSINESS xxxxxxx You're the xxxxxxx hired CFO xxxxxxx a xxxxxxx xxxxxxx company.  The xxxxxxx held firm xxxxxxx capitalized with xxxxxxx million in xxxxxxx equity and xxxxxxx million in xxxxxxx xxxxxxx bank xxxxxxx The construction xxxxxxx is quite xxxxxxx so xxxxxxx xxxxxxx 20% to xxxxxxx are normally xxxxxxx on equity xxxxxxx The bank xxxxxxx currently charging xxxxxxx on the xxxxxxx xxxxxxx but xxxxxxx rates are xxxxxxx to rise xxxxxxx the xxxxxxx xxxxxxx Your boss, xxxxxxx owner, started xxxxxxx career as xxxxxxx carpenter and xxxxxxx an excellent xxxxxxx of day-to-day xxxxxxx xxxxxxx he xxxxxxx little about xxxxxxx Business has xxxxxxx good xxxxxxx xxxxxxx several expansion xxxxxxx are under xxxxxxx A cash xxxxxxx projection has xxxxxxx made for xxxxxxx You're satisfied xxxxxxx xxxxxxx estimates xxxxxxx reasonable. 

     The xxxxxxx has called xxxxxxx in xxxxxxx xxxxxxx to being xxxxxxx about the xxxxxxx He instinctively xxxxxxx that some xxxxxxx financially marginal xxxxxxx may not xxxxxxx xxxxxxx to xxxxxxx company, but xxxxxxx doesn't know xxxxxxx to xxxxxxx xxxxxxx or to xxxxxxx among the xxxxxxx that are xxxxxxx viable.

     Assuming xxxxxxx owner understands xxxxxxx concept of xxxxxxx xxxxxxx investment, xxxxxxx a brief xxxxxxx explaining the xxxxxxx of xxxxxxx xxxxxxx cost of xxxxxxx and how xxxxxxx can solve xxxxxxx problem.  Don't xxxxxxx into the xxxxxxx mechanics of xxxxxxx xxxxxxx but xxxxxxx use the xxxxxxx given above xxxxxxx make xxxxxxx xxxxxxx estimate of xxxxxxx company's cost xxxxxxx capital, and xxxxxxx the result xxxxxxx your memo. 

 

ANSWER:  xxxxxxx business has xxxxxxx xxxxxxx for xxxxxxx funds it xxxxxxx We call xxxxxxx payment xxxxxxx xxxxxxx of the xxxxxxx and generally xxxxxxx it as xxxxxxx percentage like xxxxxxx interest rate.  xxxxxxx money, comes xxxxxxx xxxxxxx and xxxxxxx and the xxxxxxx of each xxxxxxx closely xxxxxxx xxxxxxx the returns xxxxxxx firm pays xxxxxxx investors. 

     When xxxxxxx firm considers xxxxxxx that use xxxxxxx money, it's xxxxxxx xxxxxxx estimate xxxxxxx cost in xxxxxxx pooled sense.  xxxxxxx we xxxxxxx xxxxxxx we call xxxxxxx money capital xxxxxxx develop a xxxxxxx cost figure xxxxxxx it.  Under xxxxxxx logic, the xxxxxxx xxxxxxx of xxxxxxx is an xxxxxxx of the xxxxxxx of xxxxxxx xxxxxxx equity where xxxxxxx average is xxxxxxx by the xxxxxxx of debt xxxxxxx equity in xxxxxxx In our xxxxxxx xxxxxxx company xxxxxxx financed with xxxxxxx mix that's xxxxxxx 40% xxxxxxx xxxxxxx 60% debt.  xxxxxxx cost of xxxxxxx is about xxxxxxx while the xxxxxxx tax cost xxxxxxx debt is xxxxxxx xxxxxxx neighborhood xxxxxxx 9%.  That xxxxxxx our overall xxxxxxx of xxxxxxx xxxxxxx between 13% xxxxxxx 14%. Once xxxxxxx know what xxxxxxx money costs, xxxxxxx apparent

that we xxxxxxx never use xxxxxxx xxxxxxx a xxxxxxx that returns xxxxxxx than that xxxxxxx Now xxxxxxx xxxxxxx to projects xxxxxxx a moment.  xxxxxxx earn returns xxxxxxx invested funds xxxxxxx "Internal Rates xxxxxxx Return (IRRs)".  xxxxxxx xxxxxxx the xxxxxxx on just xxxxxxx money in xxxxxxx bank xxxxxxx xxxxxxx interest rate xxxxxxx bank pays.

     xxxxxxx among projects xxxxxxx conceptually simple. xxxxxxx risks are xxxxxxx the same, xxxxxxx xxxxxxx projects xxxxxxx the highest xxxxxxx But it xxxxxxx makes xxxxxxx xxxxxxx undertake a xxxxxxx that doesn't xxxxxxx at least xxxxxxx much as xxxxxxx cost of xxxxxxx put into xxxxxxx xxxxxxx do xxxxxxx would be xxxxxxx plan to xxxxxxx money!  xxxxxxx xxxxxxx it wouldn't xxxxxxx much sense xxxxxxx put company xxxxxxx in a xxxxxxx account paying xxxxxxx because the xxxxxxx xxxxxxx us xxxxxxx Now put xxxxxxx ideas of xxxxxxx of xxxxxxx xxxxxxx IRR together.  xxxxxxx projects we're xxxxxxx all have xxxxxxx IRRs.  Anything xxxxxxx an IRR xxxxxxx 14% isn't xxxxxxx xxxxxxx idea, xxxxxxx that's less xxxxxxx what we xxxxxxx for xxxxxxx xxxxxxx we'll put xxxxxxx it. Projects xxxxxxx IRRs between xxxxxxx and about xxxxxxx are pretty xxxxxxx Those with xxxxxxx xxxxxxx may xxxxxxx ok if xxxxxxx cash projections xxxxxxx reasonable xxxxxxx xxxxxxx risks aren't xxxxxxx of line.

 

2.         xxxxxxx the CFO xxxxxxx a small xxxxxxx that is xxxxxxx a new xxxxxxx xxxxxxx president xxxxxxx several other xxxxxxx of management xxxxxxx very xxxxxxx xxxxxxx the idea xxxxxxx reasons related xxxxxxx engineering and xxxxxxx rather than xxxxxxx You've analyzed xxxxxxx proposal by xxxxxxx xxxxxxx budgeting xxxxxxx and found xxxxxxx it fails xxxxxxx IRR xxxxxxx xxxxxxx tests using xxxxxxx cost of xxxxxxx based on xxxxxxx returns.  The xxxxxxx is that xxxxxxx rates have xxxxxxx xxxxxxx in xxxxxxx last year, xxxxxxx the cost xxxxxxx capital xxxxxxx xxxxxxx high. 

     You've xxxxxxx your results xxxxxxx the management xxxxxxx who are xxxxxxx disappointed.  In xxxxxxx they'd like xxxxxxx xxxxxxx a xxxxxxx to discredit xxxxxxx analysis, so xxxxxxx can xxxxxxx xxxxxxx ahead with xxxxxxx project.  You've xxxxxxx your analysis, xxxxxxx everything seems xxxxxxx understood except xxxxxxx one point.  xxxxxxx xxxxxxx insists xxxxxxx the use xxxxxxx returns currently xxxxxxx to xxxxxxx xxxxxxx a basis xxxxxxx the cost xxxxxxx capital components xxxxxxx make sense.  xxxxxxx vice president xxxxxxx marketing put xxxxxxx xxxxxxx as xxxxxxx "Two years xxxxxxx we borrowed xxxxxxx million xxxxxxx xxxxxxx We haven't xxxxxxx it back, xxxxxxx we're still xxxxxxx interest payments xxxxxxx $100,000 every xxxxxxx Clearly, our xxxxxxx xxxxxxx debt xxxxxxx 10% and xxxxxxx the 14% xxxxxxx want xxxxxxx xxxxxxx If you'd xxxxxxx "real" cost xxxxxxx debt, as xxxxxxx as of xxxxxxx and preferred xxxxxxx the project xxxxxxx xxxxxxx qualify xxxxxxx How do xxxxxxx respond? 

     (The xxxxxxx response xxxxxxx xxxxxxx short.  It's xxxxxxx noting that xxxxxxx kind of xxxxxxx happens all xxxxxxx time in xxxxxxx Marketing and xxxxxxx xxxxxxx often xxxxxxx carried away xxxxxxx "neat" projects xxxxxxx don't xxxxxxx xxxxxxx financially.  The xxxxxxx has to xxxxxxx the bottom xxxxxxx and it's xxxxxxx unusual to xxxxxxx seen as xxxxxxx xxxxxxx blanket xxxxxxx wants to xxxxxxx the others' xxxxxxx We xxxxxxx xxxxxxx the money xxxxxxx raised two xxxxxxx ago on xxxxxxx project, because xxxxxxx already been xxxxxxx We have xxxxxxx xxxxxxx new xxxxxxx for the xxxxxxx project.  You're xxxxxxx in xxxxxxx xxxxxxx cost of xxxxxxx existing capital xxxxxxx a much xxxxxxx figure than xxxxxxx one I'm xxxxxxx But that xxxxxxx xxxxxxx irrelevant.  xxxxxxx important is xxxxxxx cost of xxxxxxx money xxxxxxx xxxxxxx raising in xxxxxxx near future xxxxxxx fund this xxxxxxx That cost xxxxxxx reflected by xxxxxxx market rates, xxxxxxx xxxxxxx much xxxxxxx than our xxxxxxx rates.

 

3.         The xxxxxxx department xxxxxxx xxxxxxx Inc. wants xxxxxxx buy a xxxxxxx state-of-the-art computer.  xxxxxxx proposed machine xxxxxxx faster than xxxxxxx one now xxxxxxx xxxxxxx but xxxxxxx the extra xxxxxxx is worth xxxxxxx expense xxxxxxx xxxxxxx given the xxxxxxx of the xxxxxxx applications.  The xxxxxxx Engineer (who xxxxxxx an MBA xxxxxxx a reasonable xxxxxxx xxxxxxx financial xxxxxxx has put xxxxxxx an enormously xxxxxxx capital xxxxxxx xxxxxxx for the xxxxxxx of the xxxxxxx machine.  The xxxxxxx concludes that xxxxxxx a great xxxxxxx You're a xxxxxxx xxxxxxx for xxxxxxx firm, and xxxxxxx been assigned xxxxxxx review xxxxxxx xxxxxxx proposal.  Your xxxxxxx has highlighted xxxxxxx problems.  First, xxxxxxx cost savings xxxxxxx as a xxxxxxx of using xxxxxxx xxxxxxx machine xxxxxxx rather optimistic.  xxxxxxx the analysis xxxxxxx an xxxxxxx xxxxxxx cost of xxxxxxx With respect xxxxxxx the second xxxxxxx the engineering xxxxxxx contains the xxxxxxx exhibit documenting xxxxxxx xxxxxxx of xxxxxxx cost of xxxxxxx used:

 

Digitech's xxxxxxx xxxxxxx is 60% xxxxxxx and 40% xxxxxxx align="center"> 

The xxxxxxx is offering xxxxxxx at 8% xxxxxxx a sales xxxxxxx xxxxxxx align="center">Cost xxxxxxx capital = xxxxxxx ´ .6 xxxxxxx 4.8%

-T) xxxxxxx 4.8%(.6) = xxxxxxx align="center"> 

 

            xxxxxxx checked the xxxxxxx and found xxxxxxx xxxxxxx bonds xxxxxxx currently selling xxxxxxx yield 14% xxxxxxx the xxxxxxx xxxxxxx returning about xxxxxxx How would xxxxxxx proceed?  That xxxxxxx explain the xxxxxxx engineer's error(s) xxxxxxx indicate the xxxxxxx xxxxxxx The xxxxxxx engineer has xxxxxxx forgotten his xxxxxxx The xxxxxxx xxxxxxx is using xxxxxxx cost of xxxxxxx financing to xxxxxxx a project xxxxxxx of the xxxxxxx of capital.  xxxxxxx xxxxxxx an xxxxxxx procedure that xxxxxxx to bad xxxxxxx in xxxxxxx xxxxxxx run although xxxxxxx will virtually xxxxxxx acceptance of xxxxxxx current project. xxxxxxx "A Potential xxxxxxx - Handling xxxxxxx xxxxxxx Projects.")  xxxxxxx top of xxxxxxx the proposal xxxxxxx part xxxxxxx xxxxxxx weighted average xxxxxxx to further xxxxxxx the interest xxxxxxx used to xxxxxxx the project.

     xxxxxxx coupled with xxxxxxx xxxxxxx cash xxxxxxx estimates makes xxxxxxx think that xxxxxxx computer xxxxxxx xxxxxxx something the xxxxxxx want but xxxxxxx really support xxxxxxx That means xxxxxxx likely to xxxxxxx an emotional xxxxxxx xxxxxxx probably xxxxxxx if you xxxxxxx go to xxxxxxx chief xxxxxxx xxxxxxx to challenge xxxxxxx proposal.  Take xxxxxxx findings to xxxxxxx CFO and xxxxxxx her approach xxxxxxx chief engineer xxxxxxx xxxxxxx and xxxxxxx the matter xxxxxxx This situation xxxxxxx something xxxxxxx xxxxxxx common.  A xxxxxxx is presented xxxxxxx so much xxxxxxx information that xxxxxxx difficult to xxxxxxx the errors xxxxxxx xxxxxxx assumptions xxxxxxx in the xxxxxxx Whitefish Inc. xxxxxxx a xxxxxxx xxxxxxx 15 fishing xxxxxxx in the xxxxxxx Atlantic Ocean.  xxxxxxx has been xxxxxxx in the xxxxxxx few years, xxxxxxx xxxxxxx the xxxxxxx for product, xxxxxxx the firm xxxxxxx sell xxxxxxx xxxxxxx fish it xxxxxxx catch.  Charlie xxxxxxx the vice xxxxxxx for operations, xxxxxxx worked up xxxxxxx capital budgeting xxxxxxx xxxxxxx the xxxxxxx of new xxxxxxx Each boat xxxxxxx viewed xxxxxxx xxxxxxx individual project xxxxxxx to the xxxxxxx and shows xxxxxxx IRR of xxxxxxx The firm's xxxxxxx of capital xxxxxxx xxxxxxx correctly xxxxxxx at 14% xxxxxxx the retained xxxxxxx break xxxxxxx xxxxxxx after that xxxxxxx Charlie argues xxxxxxx the capital xxxxxxx figures show xxxxxxx the firm xxxxxxx acquire as xxxxxxx xxxxxxx boats xxxxxxx it possibly xxxxxxx financing them xxxxxxx whatever xxxxxxx xxxxxxx finds available.  xxxxxxx are Whitefish's xxxxxxx Support or xxxxxxx Charlie's position.  xxxxxxx should the xxxxxxx number of xxxxxxx xxxxxxx be xxxxxxx Does acquiring xxxxxxx large number xxxxxxx new xxxxxxx xxxxxxx any problems xxxxxxx risks that xxxxxxx immediately apparent xxxxxxx the financial xxxxxxx Although the xxxxxxx is 15% xxxxxxx xxxxxxx retained xxxxxxx break, it xxxxxxx remain at xxxxxxx level xxxxxxx xxxxxxx more boats xxxxxxx acquired with xxxxxxx financing, the xxxxxxx of capital xxxxxxx rise and xxxxxxx exceed 22%.  xxxxxxx xxxxxxx level xxxxxxx investment in xxxxxxx boats should xxxxxxx determined xxxxxxx xxxxxxx how the xxxxxxx will behave, xxxxxxx estimating where xxxxxxx will exceed xxxxxxx Charlie's estimate xxxxxxx based on xxxxxxx xxxxxxx and xxxxxxx conditions.  If xxxxxxx conditions aren't xxxxxxx buying xxxxxxx xxxxxxx number of xxxxxxx boats could xxxxxxx the firm's xxxxxxx substantially.

 

 

PROBLEMS

 

 

WACC Calculations: xxxxxxx 13-1 (page xxxxxxx Blazingame Inc.'s xxxxxxx xxxxxxx have xxxxxxx following market xxxxxxx Debt                        xxxxxxx Preferred xxxxxxx xxxxxxx $17,500,000

     Common xxxxxxx             $48,350,000

Calculate xxxxxxx firm's capital xxxxxxx and show xxxxxxx weights that xxxxxxx be used xxxxxxx xxxxxxx weighted xxxxxxx cost of xxxxxxx (WACC) computation. 

 

SOLUTION:

                                    xxxxxxx Weights

   xxxxxxx xxxxxxx $35,180           xxxxxxx Preferred Stock     xxxxxxx $17,500           xxxxxxx Common Equity       xxxxxxx $48,350           xxxxxxx                               $101,030           xxxxxxx xxxxxxx Aztec xxxxxxx has the xxxxxxx capital components xxxxxxx costs.  xxxxxxx xxxxxxx WACC.

 

Component                  Value               xxxxxxx                       $23,625     xxxxxxx 12.0%

Preferred Stock     xxxxxxx $  4,350     xxxxxxx 13.5%

Common Equity       xxxxxxx $52,275           xxxxxxx xxxxxxx Weights            xxxxxxx Factors

Debt                             xxxxxxx         .294    xxxxxxx 12.0% xxxxxxx xxxxxxx        $  xxxxxxx         .054    xxxxxxx 13.5%     .73

Common xxxxxxx    $52,275   xxxxxxx .652*                           xxxxxxx 12.52

                                    $80,250           xxxxxxx xxxxxxx             16.78

    xxxxxxx Use WACC   xxxxxxx 16.8%

 

     *Rounding xxxxxxx causes xxxxxxx xxxxxxx to sum xxxxxxx a figure xxxxxxx different from xxxxxxx When that xxxxxxx we generally xxxxxxx one figure xxxxxxx xxxxxxx way xxxxxxx show weights xxxxxxx add to xxxxxxx 1.000.

 

 

                        xxxxxxx Stock                                    $15,000,000

                        xxxxxxx xxxxxxx Excess                          $15,000,000

 

 

            Calculate xxxxxxx capital structure xxxxxxx on book xxxxxxx xxxxxxx style="margin-left:36.0pt;">SOLUTION xxxxxxx style="margin-left:36.0pt;">                                                                                 %

            xxxxxxx xxxxxxx 15.0                   8.7

92.5                 xxxxxxx style="margin-left:36.0pt;">            Total                                xxxxxxx 100.0

 

Market Value xxxxxxx Capital Structure: xxxxxxx xxxxxxx (page xxxxxxx style="margin-left:36.0pt;">4.         Referring xxxxxxx Willerton Industries xxxxxxx the xxxxxxx xxxxxxx the company’s xxxxxxx term debt xxxxxxx comprised of xxxxxxx $1,000 face xxxxxxx bonds issued xxxxxxx years ago xxxxxxx xxxxxxx 8% xxxxxxx rate.  The xxxxxxx are now xxxxxxx to xxxxxxx xxxxxxx Willerton’s preferred xxxxxxx from a xxxxxxx issue of xxxxxxx par value, xxxxxxx preferred stock xxxxxxx is now xxxxxxx xxxxxxx yield xxxxxxx Willerton has xxxxxxx million shares xxxxxxx common xxxxxxx xxxxxxx at a xxxxxxx market price xxxxxxx $31.  Calculate xxxxxxx market value xxxxxxx capital structure.

SOLUTION:

a.         xxxxxxx xxxxxxx of xxxxxxx style="margin-left:36.0pt;">            n xxxxxxx 13 x xxxxxxx = xxxxxxx xxxxxxx FV = xxxxxxx style="margin-left:36.0pt;">            I/Y xxxxxxx 6/2 = xxxxxxx style="margin-left:36.0pt;">            PMT xxxxxxx 1,000 x xxxxxxx = 40

            Market xxxxxxx of xxxxxxx xxxxxxx style="margin-left:36.0pt;">            Number xxxxxxx preferred shares xxxxxxx previous problem

            $9/.08 xxxxxxx $112.50

 

     Market xxxxxxx %

            xxxxxxx $1,178.77 xxxxxxx xxxxxxx $76,620,050                                35.2

            xxxxxxx $31 x xxxxxxx 124,000,000                                57.0

 

5.         xxxxxxx referring to xxxxxxx of xxxxxxx xxxxxxx previous problems, xxxxxxx the firm’s xxxxxxx of retained xxxxxxx is 11% xxxxxxx its marginal xxxxxxx rate is xxxxxxx xxxxxxx its xxxxxxx using its xxxxxxx value based xxxxxxx structure xxxxxxx xxxxxxx costs.  Make xxxxxxx same calculation xxxxxxx the market xxxxxxx based capital xxxxxxx  How significant xxxxxxx the difference?

 

Book Value

            Preferred  xxxxxxx x 8%                                       xxxxxxx style="margin-left:36.0pt;">            Equity  xxxxxxx x 11%                                        xxxxxxx style="margin-left:36.0pt;">            WACC                                                           xxxxxxx xxxxxxx style="margin-left:36.0pt;">            xxxxxxx Value

            xxxxxxx .352 x xxxxxxx x xxxxxxx xxxxxxx .4)                           1.27

6.27

 

 

6.         xxxxxxx relatively young xxxxxxx has capital xxxxxxx valued at xxxxxxx xxxxxxx market xxxxxxx market component xxxxxxx as follows.  xxxxxxx new xxxxxxx xxxxxxx been issued xxxxxxx the firm xxxxxxx originally capitalized.

 

                                                xxxxxxx                        Market

Component  xxxxxxx Market             xxxxxxx                  Cost

Debt       xxxxxxx xxxxxxx          xxxxxxx      8.5%

Preferred xxxxxxx        $10,650  xxxxxxx $10,000     xxxxxxx xxxxxxx Equity          xxxxxxx          $32,000     xxxxxxx 25.3%

 

 a. Calculate xxxxxxx firm's capital xxxxxxx and WACCs xxxxxxx on both xxxxxxx xxxxxxx market xxxxxxx and compare xxxxxxx two. 

 b. What xxxxxxx to xxxxxxx xxxxxxx to interest xxxxxxx since the xxxxxxx was started? 

 c. xxxxxxx the firm xxxxxxx to be xxxxxxx Why? 

 d. What xxxxxxx xxxxxxx the xxxxxxx of using xxxxxxx WACC based xxxxxxx book xxxxxxx xxxxxxx to market xxxxxxx In other xxxxxxx what kinds xxxxxxx mistakes might xxxxxxx make by xxxxxxx the book xxxxxxx xxxxxxx    xxxxxxx Market             xxxxxxx Book    xxxxxxx       xxxxxxx xxxxxxx Market    Book

Debt   xxxxxxx $42,830     .359    xxxxxxx $40,000    .488  xxxxxxx             8.5%   xxxxxxx    4.15

Preferred Stock  xxxxxxx $10,650     .090    xxxxxxx xxxxxxx .122    xxxxxxx 10.6%              xxxxxxx    1.29

Common Equity   xxxxxxx $65,740     xxxxxxx xxxxxxx $32,000    .390 xxxxxxx 25.3%   13.94  xxxxxxx    9.87

                                   xxxxxxx 1.000          xxxxxxx 1.000                        xxxxxxx 15.31

                                                                                                Use xxxxxxx xxxxxxx 17.9%    xxxxxxx The overall xxxxxxx of capital xxxxxxx risen xxxxxxx xxxxxxx the net xxxxxxx of a xxxxxxx increase in xxxxxxx value of xxxxxxx firm's equity.  xxxxxxx throws more xxxxxxx xxxxxxx high xxxxxxx into the xxxxxxx Interest rates xxxxxxx to xxxxxxx xxxxxxx since the xxxxxxx values of xxxxxxx and preferred xxxxxxx their original xxxxxxx The firm xxxxxxx to be xxxxxxx xxxxxxx of xxxxxxx substantial increase xxxxxxx the value xxxxxxx equity.  xxxxxxx xxxxxxx be due xxxxxxx an increase xxxxxxx stock price xxxxxxx a rapid xxxxxxx of retained xxxxxxx or a xxxxxxx xxxxxxx both.

 

d.  xxxxxxx the book xxxxxxx WACC might xxxxxxx to xxxxxxx xxxxxxx that wouldn't xxxxxxx the expectations xxxxxxx have for xxxxxxx company's return.

 

7. xxxxxxx Five years xxxxxxx Hemingway Inc. xxxxxxx xxxxxxx thirty-year xxxxxxx with par xxxxxxx of $1,000 xxxxxxx a xxxxxxx xxxxxxx of 8%.  xxxxxxx bonds are xxxxxxx selling to xxxxxxx 5%.  The xxxxxxx also has xxxxxxx shares of xxxxxxx xxxxxxx outstanding xxxxxxx pay a xxxxxxx of $6.50 xxxxxxx share.  xxxxxxx xxxxxxx currently selling xxxxxxx yield 10%.  xxxxxxx common stock xxxxxxx selling at xxxxxxx and 200,000 xxxxxxx are outstanding.  xxxxxxx xxxxxxx market xxxxxxx based capital xxxxxxx The current xxxxxxx of xxxxxxx xxxxxxx is

            xxxxxxx = PMT[PVFAk,n] xxxxxxx FV[PVFk,n]

            xxxxxxx = $40[PVFA2.5,50] xxxxxxx $1,000[PVF2.5,50]

            xxxxxxx = $40[28.3623] xxxxxxx xxxxxxx style="margin-left:36.0pt;">            xxxxxxx = $1,134.49 xxxxxxx $290.90

            xxxxxxx = xxxxxxx xxxxxxx value of xxxxxxx bonds is

                                    xxxxxxx ´ 6,000 xxxxxxx $8,552,340

The preferred xxxxxxx shares are xxxxxxx worth

                                    PP xxxxxxx xxxxxxx / xxxxxxx = $65.00

In xxxxxxx they’re worth

                                    xxxxxxx ´ xxxxxxx xxxxxxx $975,000

            The xxxxxxx value of xxxxxxx stock is xxxxxxx $21.00 ´ xxxxxxx = $4,200,000

            xxxxxxx capital is xxxxxxx xxxxxxx of xxxxxxx figures and xxxxxxx structure is xxxxxxx component xxxxxxx xxxxxxx the total xxxxxxx as a xxxxxxx Component                         Value       xxxxxxx     Capital xxxxxxx    Debt                          xxxxxxx 8,552,340                              xxxxxxx xxxxxxx Preferred                   xxxxxxx 975,000                                xxxxxxx    Equity                       xxxxxxx   4,200,000    xxxxxxx xxxxxxx 30.6%

                            xxxxxxx Capital                        $13,727,340                            xxxxxxx         The xxxxxxx Company has xxxxxxx shares of xxxxxxx stock outstanding xxxxxxx xxxxxxx currently xxxxxxx at $28.63.  xxxxxxx has 4,530 xxxxxxx outstanding xxxxxxx xxxxxxx mature for xxxxxxx years.  They xxxxxxx issued at xxxxxxx par value xxxxxxx $1,000 paying xxxxxxx coupon rate xxxxxxx xxxxxxx Comparable xxxxxxx now yield xxxxxxx Wall’s $100 xxxxxxx value xxxxxxx xxxxxxx was issued xxxxxxx 8% and xxxxxxx now yielding xxxxxxx 7,500 shares xxxxxxx outstanding.  Develop xxxxxxx market value xxxxxxx xxxxxxx structure. 

 

SOLUTION:

            xxxxxxx current price xxxxxxx the bonds xxxxxxx style="margin-left:36.0pt;">            xxxxxxx xxxxxxx PMT[PVFAk,n] + xxxxxxx style="margin-left:36.0pt;">            PB xxxxxxx $30[PVFA4.5,40] + xxxxxxx style="margin-left:36.0pt;">            PB xxxxxxx $30[18.4016] + xxxxxxx style="margin-left:36.0pt;">            PB xxxxxxx xxxxxxx + xxxxxxx style="margin-left:36.0pt;">            PB xxxxxxx $723.95

The market xxxxxxx of xxxxxxx xxxxxxx is

                                    $723.95 xxxxxxx 4,530 = xxxxxxx preferred stock xxxxxxx pay a xxxxxxx of ($100x.08=) xxxxxxx and are xxxxxxx xxxxxxx PP xxxxxxx $8.00 / xxxxxxx = $72.73

In xxxxxxx they’re xxxxxxx xxxxxxx ´ 7,500 xxxxxxx $545,475

            The xxxxxxx value of xxxxxxx common stock xxxxxxx $28.63 ´ xxxxxxx = $4,079,775

            xxxxxxx xxxxxxx is xxxxxxx sum of xxxxxxx figures and xxxxxxx structure xxxxxxx xxxxxxx component divided xxxxxxx the total xxxxxxx as a xxxxxxx Component                      Value   xxxxxxx     Capital Structure

                        xxxxxxx Debt                          $3,279,494                              xxxxxxx xxxxxxx    xxxxxxx      545,475                              xxxxxxx 6.9%

                           xxxxxxx   xxxxxxx xxxxxxx 51.6%

                            xxxxxxx Capital                        $7,904,744                              xxxxxxx The market xxxxxxx of Albertson xxxxxxx common stock xxxxxxx $5.50, and xxxxxxx xxxxxxx are xxxxxxx The firm's xxxxxxx show common xxxxxxx accounts xxxxxxx xxxxxxx There are xxxxxxx preferred shares xxxxxxx that originally xxxxxxx for their xxxxxxx value of xxxxxxx pay an xxxxxxx xxxxxxx of xxxxxxx and are xxxxxxx selling to xxxxxxx an xxxxxxx xxxxxxx Also, 200 xxxxxxx outstanding that xxxxxxx issued five xxxxxxx ago at xxxxxxx $1,000 face xxxxxxx for 30-year xxxxxxx xxxxxxx a xxxxxxx rate of xxxxxxx and are xxxxxxx selling xxxxxxx xxxxxxx 10%.  Develop xxxxxxx capital structure xxxxxxx on both xxxxxxx and market xxxxxxx

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