Chapter 11 Discussion Questions 11-1 Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used(e.g, debt)? Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm l1-2 How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10? The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why? In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs We must consider what these funds will cost us to finance projects in the future rather than their past costs 11-4 Why is the cost of debt less than the cost of preferred stock if both securities are d to yield 10 percent in the market? Even though debt and preferred stock may be both priced to yield 10 percent in the market the cost of debt is less because the interest on debt is a tax deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate) l1-5 What are the two sources of equity(ownership) capital for the firm? The two sources of equity capital are retained earnings and ommon stock 11-6. Explain why retained Retained earnings belong to the existing common stockholders. If the funds paid out instead of reinvested, the stockholders could earn a return on them Thus, we say retaining funds for reinvestment carries an opportunity cost iby The McGraw-Hill Co
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-379 Chapter 11 Discussion Questions 11-1. Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)? Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm. 11-2. How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10? The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation. 11-3. In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why? In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs. 11-4. Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a taxdeductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate). 11-5. What are the two sources of equity (ownership) capital for the firm? The two sources of equity capital are retained earnings and new common stock. 11-6. Explain why retained earnings have an opportunity cost associated? Retained earnings belong to the existing common stockholders. If the funds are paid out instead of reinvested, the stockholders could earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost
11-7 Why is the cost of retained earnings the equivalent of the firms own required rate of return on common stock (Ke)? Because stockholders can earn a return at least equal to their present investment. For this reason, the firm s rate of return(Ke) serves as a means of approximating the opportunities for alternate investments 11-8. Why is the cost of issuing new common stock(Kn) higher than the cost of retained earnings(Ke)? In issuing new common we must earn a slightly higher return than the normal cost of common in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher l1-9 How are the weights determined to arrive at the optimal weighted average cost The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights l1-10 Explain the trad itional, U-shaped approach to the cost of capital The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped l1-11 It has often been said that if the company can,'t earn a rate of return greater than the cost of capital it should not make investments. Explain If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm,s operations and will lower the overall wealth of the shareholder Clearly, it is undesirable to invest in a project yield ing 8 percent if the financing cost is 10 percent CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-380 11-7. Why is the cost of retained earnings the equivalent of the firm's own required rate of return on common stock (Ke)? Because stockholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return (Ke) serves as a means of approximating the opportunities for alternate investments. 11-8. Why is the cost of issuing new common stock (Kn) higher than the cost of retained earnings (Ke)? In issuing new common stock, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher. 11-9. How are the weights determined to arrive at the optimal weighted average cost of capital? The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights. 11-10. Explain the traditional, U-shaped approach to the cost of capital. The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped. 11-11. It has often been said that if the company can't earn a rate of return greater than the cost of capital it should not make investments. Explain. If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm's operations and will lower the overall wealth of the shareholders. Clearly, it is undesirable to invest in a project yielding 8 percent if the financing cost is 10 percent
l1-12 What effect would inflation have on a company' s cost of capital?(Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth Inflation can only have a negative impact on a firm s cost of capital-forcing it to go up. This is true because inflation tends to increase interest rates and lower stock prices, thus raising the cost of debt and equity directly and the cost of preferred stock ind irectly 11-13 What is the concept of marginal cost of capital? The marginal cost of capital is the cost of incremental funds. After a firm reaches a given level of financing, capital costs will go up because the firm must tap more expensive sources. For example, new common stock may be needed to replace retained earnings as a source of equity capital Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-381 11-12. What effect would inflation have on a company's cost of capital? (Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth.) Inflation can only have a negative impact on a firm's cost of capital-forcing it to go up. This is true because inflation tends to increase interest rates and lower stock prices, thus raising the cost of debt and equity directly and the cost of preferred stock indirectly. 11-13. What is the concept of marginal cost of capital? The marginal cost of capital is the cost of incremental funds. After a firm reaches a given level of financing, capital costs will go up because the firm must tap more expensive sources. For example, new common stock may be needed to replace retained earnings as a source of equity capital
Appendix a Discussion Questions 11A-1 How does the capital asset pricing model help explain changing costs of The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly 11A-2. How does the Sml react to changes in the rate of interest. changes in the rate of inflation, and changing investor expectations? The SML, Security Market Line, reflects the risk-return tradeoffs of securities As interest rates increase, the SMl moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the sml In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired(see figure 11A-4) CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-382 Appendix A Discussion Questions 11A-1. How does the capital asset pricing model help explain changing costs of capital? The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return. As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly. 11A-2. How does the SML react to changes in the rate of interest, changes in the rate of inflation, and changing investor expectations? The SML, Security Market Line, reflects the risk-return tradeoffs of securities. As interest rates increase, the SML moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the SML. In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired (see figure 11A-4)
oems Rambo Exterminator Company bought a"Bug Eradicator" in April of 2004 that provided a return of 7 percent. It was financed by debt costing 6 percent. In August, Mr. Rambo came up with an " entire bug colony destroying device that had a return of 12 percent. The Chief Financial Officer, Mr. Roach, told him it of 13.5 percent to finance the purchase Is the company following a logica/Cost was impractical because it would require the issuance of common stock at a cost approach to using its cost of capital Solution Rambo Exterminator Company No, each individual project should not be measured against the specific means of financing that project, but rather against the weighted average cost of financing all projects for the firm This principle recognizes that the availability of one source of financing is dependent on other sources. Once a common overall cost is determined, the colony destroying device yielding 12 percent is much more likely to be accepted than the bug eradicator"only yielding 7 percent 11-2 Sullivan Cement Company can issue debt yielding 13 percent. The company paying a 36 percent rate. What is the aftertax cost of debt? Solution: Sullivan Cement Company Kd Yield(1-T =13%(1-.36) 13%(64) =8.32% Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-383 Problems 11-1. Rambo Exterminator Company bought a “Bug Eradicator” in April of 2004 that provided a return of 7 percent. It was financed by debt costing 6 percent. In August, Mr. Rambo came up with an “entire bug colony destroying” device that had a return of 12 percent. The Chief Financial Officer, Mr. Roach, told him it was impractical because it would require the issuance of common stock at a cost of 13.5 percent to finance the purchase. Is the company following a logical approach to using its cost of capital. Solution: Rambo Exterminator Company No, each individual project should not be measured against the specific means of financing that project, but rather against the weighted average cost of financing all projects for the firm. This principle recognizes that the availability of one source of financing is dependent on other sources. Once a common overall cost is determined, the “colony destroying device” yielding 12 percent is much more likely to be accepted than the “bug eradicator” only yielding 7 percent. 11-2. Sullivan Cement Company can issue debt yielding 13 percent. The company is paying a 36 percent rate. What is the aftertax cost of debt? Solution: Sullivan Cement Company Kd = Yield (1 – T) = 13% (1 – .36) = 13% (.64) = 8.32%
Calculate the aftertax cost of debt under each of the following cond itions Yield Corporate Tax Rate a.8.0% 18% b.120% 34% c.10.6% 15% Solution: Kd Yield(1-T Yield Yield (1-T) a.8.0% (1-.18) 6.56% b.120% 792% C.10.6% 9.01% 11-4 The Millennium Charitable Foundation, which is tax-exempt, issued debt last year at 8 percent to help finance a new playground facility in Chicago. This year the cost of debt is 15 percent higher; that is, firms that paid 10 percent for debt last year would be paying 11.5 percent this year a. If the Millennium Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 15 percent increase? b. If the Foundation was found to be taxable by the irS (at a rate of 35 percent) because it was involved in political activities, what would the aftertax cost of debt be? Solution: Millennium Charitable foundati K Yield(1-T Yield=8%X1.15=9.20% K 92%(1-0)=9.2%(1)=9.2% b K 92%(1-35)=92%(65)=5.98% CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-384 11-3. Calculate the aftertax cost of debt under each of the following conditions. Yield Corporate Tax Rate a. 8.0% 18% b. 12.0% 34% c. 10.6% 15% Solution: Kd = Yield (1 – T) Yield (1 – T) Yield (1 – T) a. 8.0% (1 – .18) 6.56% b. 12.0% (1 – .34) 7.92% c. 10.6% (1 – .15) 9.01% 11-4. The Millennium Charitable Foundation, which is tax-exempt, issued debt last year at 8 percent to help finance a new playground facility in Chicago. This year the cost of debt is 15 percent higher; that is, firms that paid 10 percent for debt last year would be paying 11.5 percent this year. a. If the Millennium Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 15 percent increase? b. If the Foundation was found to be taxable by the IRS (at a rate of 35 percent) because it was involved in political activities, what would the aftertax cost of debt be? Solution: Millennium Charitable Foundation a. Kd = Yield (1 – T) Yield = 8% x 1.15 = 9.20% Kd = 9.2% (1 – 0) = 9.2% (1) = 9.2% b. Kd = 9.2% (1 – 35) = 9.2% (65) = 5.98%
Waste Disposal Systems, Inc, has an aftertax cost of debt of 6 percent. With a tax rate of 33 percent, what can you assume the yield on the debt is? Solution: Waste Disposal Systems, Inc. K=Yield(1-T) K Yield 6%6% Yield 8.95% (1-.3)67 9% is an acceptable answer l1-6 Addison glass Company has a $1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of $88 and is currently selling for $925. Addison is in a 25 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar a. Compute the approximate yield to maturity(formula 11-1)on the old issue and use this as the yield for the new issue b. Make the appropriate tax adjustment to determine the aftertax cost of debt 385 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-385 11-5. Waste Disposal Systems, Inc., has an aftertax cost of debt of 6 percent. With a tax rate of 33 percent, what can you assume the yield on the debt is? Solution: Waste Disposal Systems, Inc. ( ) ( ) 8.95% .67 6% 1 .33 6% Yield 1 T K Yield K Yield (1 T) d d = = − = − = = − 9% is an acceptable answer. 11-6. Addison Glass Company has a $1,000 par value bond outstanding with 25 years to maturity. The bond carries an annual interest payment of $88 and is currently selling for $925. Addison is in a 25 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar. a. Compute the approximate yield to maturity (Formula 11-1) on the old issue and use this as the yield for the new issue. b. Make the appropriate tax adjustment to determine the aftertax cost of debt
1-6. Continued Solution: Addison Glass Company Principal payment- Price of the bond Annual interest payment Number of years to maturity 6(Price of bond)+ 4 (Principal payment) S8$1000-$925 6(925)+4($1000 $75 $88+ $555+$400 $88+$3 $955 $9l 953% $955 b Kd yield 953%(1-25) =953%(75) 7.15% CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-386 11-6. Continued Solution: Addison Glass Company a. .6 (Price of bond) .4 (Principal payment) Number of years to maturity Principal payment Price of the bond Annual interest payment Y' + − + = ( ) ( ) 9.53% $955 $91 $955 $88 $3 $555 $400 25 $75 $88 .6 $925 .4 $1,000 25 $1,000 $925 $88 = = + = + + = + − + = b. Kd = Yield (1 – T) = 9.53% (1 – .25) = 9.53% (.75) = 7.15%
Hewlett Software Corporation has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $110 and is currently selling for $1, 080 per bond. Hewlett is in a 35 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar a. Compute the approximate yield to maturity( formula 11-1)on the old issue and use this as the yield for the new issue Make the appropriate tax adjustment to determine the aftertax cost of debt Solution: Hewlett Software Corporation Principal payment- Price of the bond Annual interest payment Number of years to maturity 6(Price of bond)+ 4 (Principal payment) $l10+ $1,000-$1,080 20 6($1,080)+4($1000 $l10+ $80 20 $648+$400 $l10-$4 $l.048 $106 =10.11 $l,048 iby The McGraw-Hill Co
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-387 11-7. Hewlett Software Corporation has a $1,000 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $110 and is currently selling for $1,080 per bond. Hewlett is in a 35 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar. a. Compute the approximate yield to maturity (Formula 11-1) on the old issue and use this as the yield for the new issue. b. Make the appropriate tax adjustment to determine the aftertax cost of debt. Solution: Hewlett Software Corporation a. .6 (Price of bond) .4 (Principal payment) Number of years to maturity Principal payment Price of the bond Annual interest payment Y' + − + = ( ) ( ) 10.11% $1,048 $106 $1,048 $110 $4 $648 $400 20 $80 $110 .6 $1,080 .4 $1,000 20 $1,000 $1,080 $110 = = − = + − + = + − + =
1-7. Continued b Kd= Yield(1-T 10.11%(1-35) 10.11%(65) 6.57% l1-8 For Hewlett Software Corporation, described in problem 7, assume that the yield on the bonds goes up by I percentage point and that the tax rate is now 4. percent a. What is the new aftertax cost of debt? b. Has the aftertax cost of debt gone up or down from problem 7? Explain wny Solution: Hewlett Software Corporation( Continued) a. Kd= Yield (1-T 11.11%(1-45) 11.11%(55) 6.11% b. It has gone down. Although the before-tax yield is higher, the larger tax deduction(45 percent versus 35 percent) more than offsets the higher rate CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-388 11-7. Continued b. Kd = Yield (1 – T) = 10.11% (1 – .35) = 10.11% (.65) = 6.57% 11-8. For Hewlett Software Corporation, described in problem 7, assume that the yield on the bonds goes up by 1 percentage point and that the tax rate is now 45 percent. a. What is the new aftertax cost of debt? b. Has the aftertax cost of debt gone up or down from problem 7? Explain why. Solution: Hewlett Software Corporation (Continued) a. Kd = Yield (1 – T) = 11.11% (1 – .45) = 11.11% (.55) = 6.11% b. It has gone down. Although the before-tax yield is higher, the larger tax deduction (45 percent versus 35 percent) more than offsets the higher rate
