Chapter 11, Solutions
Cornett, Adair, and Nofsinger
CHAPTER 11 – CALCULATING THE COST OF CAPITAL
Questions
LG1
11-1
How would you handle calculating the cost of capital if a firm were planning two
issue two different classes of common stock?
Solution:
As the two different classes of common stock are likely to have different component
costs, calculate the cost and weight for each separately.
LG2
Why don’t we multiply the cost of preferred stock by 1 minus the tax rate, as we do
for debt?
11-2
Solution:
Because dividends on preferred stock, unlike interest on debt, are paid out of aftertax income.
LG2
Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the
WACC?
11-3
Solution:
The theoretical minimum WACC would be that for an all-debt firm: iD × (1-TC)
LG3
Under what situations would you want to use the CAPM approach for estimating the
component cost of equity? The Constant-Growth model?
11-4
Solution:
You would want to use the CAPM when you can estimate the firm’s beta with a good
deal of certainty: you would only want to use the constant-growth model if the firm’s
stock is expected to experience constant dividend growth.
LG3
Could you calculate the component cost of equity for a stock with nonconstant
expected growth rate in dividends if you didn’t have the information necessary to
compute the component cost using the CAPM? Why or why not?
11-5
Solution:
You could try and adjust the constant growth model for initial periods of
nonconstant growth, but doing so would require estimating the growth rate for all of
the nonconstant growth periods.
LG4
Why do we use market-based weights instead of book-value-based weights when
computing the WACC?
11-6
Solution:
Because we’re interested in determining what the cost of financing the firm’s assets
would be given today’s market situation and the component costs the firm currently
faces, not what the historic prices would have been.
LG5
Suppose your firm wanted to expand into a new line of business quickly, and that
management anticipated that the new line of business would constitute over 80
11-7
11-1
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
percent of your firm’s operations within 3 years. If the expansion was going to be
financed partially with debt, would it still make sense to use the firm’s existing cost
of debt, or should you compute a new rate of return for debt based on the new line of
business?
Solution:
Given that the new line of business will comprise so much of the firm’s operations, it
probably isn’t appropriate to count on the current, existing operations to pay off the
debt. Therefore, the fir should probably compute a new required rate of return for
this firm’s debt.
LG6
Explain why the divisional cost of capital approach may cause problems if new
projects are assigned to the wrong division.
11-8
Solution:
If projects are assigned to the wrong division, the risk of that division may be
significantly different than the risk of the project, implying that the project will be
evaluated with a divisional cost of capital that is much different from what a projectspecific cost of capital would be.
LG7
When will the subjective approach to forming divisional WACCs be better than
using the firm-wide WACC to evaluate all projects?
11-9
Solution:
LG8
As long as the subjective approaches manages to use divisional costs of capital that
are, on average, closer to what the project-specific costs of capital would be than
the firm-wide cost of capital is, the subjective approach will improve the firm’s
accept/reject decisions.
11-10 Suppose a new project was going to be financed partially with retained earnings.
What flotation costs should you use for retained earnings?
Solution:
Retained earnings do not carry any flotation cost, so you should use a cost of zero.
Problems
Basic Problems
LG3
11-1
Solution:
Diddy Corp stock has a beta of 1.2, the current risk-free rate is 5 percent, and the
expected return on the market is 13.5 percent. What is Diddy’s cost of equity?
Using equation 11-2:
iE  i f   E  E  iM   i f 
 .05  1.2 .135  .05
 .15
11-2
Chapter 11, Solutions
LG3
11-2
Solution:
Cornett, Adair, and Nofsinger
JaiLai Cos. stock has a beta of 1.1, the current risk-free rate is 6.2 percent, and the
expected return on the market is 12 percent. What is JaiLai’s cost of equity?
Using equation 11-2:
iE  i f   E  E  iM   i f 
 .062  1.1.12  .062 
 .1258
LG3
11-3
Solution:
Oberon Inc. has a $20 million (face value) bond issue selling for 97 percent of par
that pays an annual coupon of 8.25 percent. What would be Oberon’s before-tax
component cost of debt?
Solving equation 11-5 for iD:

1


1  1  i 10
 D

Solve $970  $82.50  

iD








  $1, 000  for iD
 1  iD 10 



Yields iD = .087115, or 8.7115%
LG3
11-4
Solution:
KatyDid Clothes has a $150 million (face value) bond issue selling for 104 percent
of par that carries a coupon rate of 11 percent, paid semiannually. What would be
Katydid’s before-tax component cost of debt?
Solving equation 11-5 for iD:

1





1  1  i 40 


$1,
000


D

Solve $1,040  $55  
for iD
40 


i
1

i


D


D






Yields iD = .052586, or 5.2586% on a semiannual basis. Since the cost of debt is
normally quoted on a nominal annual basis, we should multiple this semiannual rate
by two to get a quoted component cost of 5.2586% × 2 = 10.5172%
LG3
11-5
Solution:
ILK has preferred stock selling for 97 percent of par that pays an 8 percent annual
coupon. What would be ILK’s component cost of preferred stock?
Using equation 11-4:
11-3
Chapter 11, Solutions
iP 
Cornett, Adair, and Nofsinger
D1
P0
$8
$97
 .0825, or 8.25%

LG3
11-6
Solution:
Marme Inc. has preferred stock selling for 137 percent of par that pays an 11 percent
annual coupon. What would be Marme’s component cost of preferred stock?
Using equation 11-4:
iP 
D1
P0
$11
$137
 .0803, or 8.03%

LG4
11-7
Solution:
FarCry Industries, a maker of telecommunications equipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
10 thousand bonds. If the common shares are selling for $27 per share, the preferred
share are selling for $14.50 per share, and the bonds are selling for 98 percent of par,
what would be the weight used for equity in the computation of FarCry’s WACC?
Using the computation for equity weight given in equation 11-1:
E
2, 000, 000  $27

E  P  D 2, 000, 000  $27  1, 000, 000  $14.50  10, 000  .98  $1, 000
$54, 000, 000

$78,300, 000
 .6897, or 68.97%
LG4
11-8
Solution:
OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of
preferred stock outstanding, and 5 thousand bonds. If the common shares are selling
for $17 per share, the preferred share are selling for $26 per share, and the bonds are
selling for 108 percent of par, what would be the weight used for equity in the
computation of OMG’s WACC?
Using the computation for equity weight given in equation 11-1:
11-4
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
4, 000, 000  $17

E  P  D 4, 000, 000  $17  3, 000, 000  $26  5, 000 1.08  $1, 000
$68, 000, 000

$151, 400, 000
 .4491, or 44.91%
LG4
11-9
Solution:
FarCry Industries, a maker of telecommunications equipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
10 thousand bonds. If the common shares are selling for $27 per share, the preferred
share are selling for $14.50 per share, and the bonds are selling for 98 percent of par,
what weight should you use for debt in the computation of FarCry’s WACC?
Using the computation for equity weight given in equation 11-1:
E
2, 000, 000  $27

E  P  D 2, 000, 000  $27  1, 000, 000  $14.50  10, 000  .98  $1, 000
$9,800, 000

$78,300, 000
 .1252, or 12.52%
LG4
11-10 OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of
preferred stock outstanding, and 5 thousand bonds. If the common shares are selling
for $17 per share, the preferred share are selling for $26 per share, and the bonds are
selling for 108 percent of par, what weight should you use for debt in the
computation of OMG’s WACC?
Solution:
Using the computation for equity weight given in equation 11-1:
E
5, 000 1.08  $1, 000

E  P  D 4, 000, 000  $17  3, 000, 000  $26  5, 000 1.08  $1, 000
$5, 400, 000

$151, 400, 000
 .0357, or 3.57%
LG4
11-11 FarCry Industries, a maker of telecommunications equipment, has 2 million shares
of common stock outstanding, 1 million shares of preferred stock outstanding, and
10 thousand bonds. If the common shares sell for $27 per share, the preferred shares
sell for $14.50 per share, and the bonds sell for 98 percent of par, what weight
should you use for preferred stock in the computation of FarCry’s WACC?
Solution:
Using the computation for equity weight given in equation 11-1:
11-5
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
2, 000, 000  $27

E  P  D 2, 000, 000  $27  1, 000, 000  $14.50  10, 000  .98  $1, 000
$14,500, 000

$78,300, 000
 .1852, or 18.52%
LG4
11-12 OMG Inc. has 4 million shares of common stock outstanding, 3 million shares of
preferred stock outstanding, and 5 thousand bonds. If the common shares sell for
$17 per share, the preferred share sell for $26 per share, and the bonds sell for 108
percent of par, what weight should you use for preferred stock in the computation of
OMG’s WACC?
Solution:
Using the computation for equity weight given in equation 11-1:
E
3, 000, 000  $26

E  P  D 4, 000, 000  $17  3, 000, 000  $26  5, 000 1.08  $1, 000
$78, 000, 000

$151, 400, 000
 .5152, or 51.52%
Intermediate Problems
LG2
11-13 Suppose that TapDance, Inc.’s capital structure features 65 percent equity, 35
percent debt, and that its before-tax cost of debt is 8 percent, while its cost of equity
is 13 percent. If the appropriate weighted average tax rate is 34 percent, what will
be TapDance’s WACC?
Solution:
Using equation 11-1:
E
P
D
iE 
iP 
iD  1  TC 
EPD
EPD
EPD
 .65  13%  0  0%  .35  8%  1  .34 
WACC 
 10.298%
LG2
11-14 JLP Industries has 6.5 million shares of common stock outstanding with a market
price of $14.00 per share. The company also has outstanding preferred stock with a
market value of $10 million, and 25,000 bonds outstanding, each with face value
$1,000 and selling at 90% of par value. The cost of equity is 14%, the cost of
preferred is 10%, and the cost of debt is 7.25%. If JLP's tax rate is 34%, what is the
WACC?
Solution:
Using equation 11-1:
11-6
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
P
D
iE 
iP 
iD  1  TC 
EPD
EPD
EPD
6,500, 000  $14

 14%
6,500, 000  $14  $10, 000, 000  25, 000  $1, 000  .9
$10, 000, 000

 10%
6,500, 000  $14  $10, 000, 000  25, 000  $1, 000  .9
25, 000  $1, 000  .9

 7.25%  1  .34 
6,500, 000  $14  $10, 000, 000  25, 000  $1, 000  .9
$91, 000, 000

 14%
$91, 000, 000  $10, 000, 000  22,500, 000
$10, 000, 000

 10%
$91, 000, 000  $10, 000, 000  22,500, 000
22,500, 000

 7.25%  1  .34 
$91, 000, 000  $10, 000, 000  22,500, 000
WACC 
 ..7368  14%  .0810  10%  .1822  7.25%  1  .34 
 11.9973%
LG2
11-15 Suppose that JB Cos. has a capital structure of 78 percent equity, 22 percent debt,
and that its before-tax cost of debt is 11 percent while its cost of equity is 17 percent.
If the appropriate weighted average tax rate is 25 percent, what will be JB’s WACC?
Solution:
Using equation 11-1:
E
P
D
iE 
iP 
iD  1  TC 
EPD
EPD
EPD
 .78  17%  0  0%  .22  11%  1  .25 
WACC 
 15.075%
LG2
11-16 Suppose that B2B, Inc. has a capital structure of 37 percent equity, 17 percent
preferred stock, and 46 percent debt. If the before-tax component costs of equity,
preferred stock and debt are 14.5 percent, 11 percent and 9.5 percent, respectively,
what is B2B’s WACC if the firm faces an average tax rate of 30%?
Solution:
Using equation 11-1:
11-7
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
P
D
iE 
iP 
iD  1  TC 
EPD
EPD
EPD
 .37  14.5%  .17  11%  .46  9.5%  1  .30 
WACC 
 9.859%
LG2
11-17 Suppose that MNINK Industries’ capital structure features 63 percent equity, 7
percent preferred stock, and 30 percent debt. If the before-tax component costs of
equity, preferred stock and debt are 11.60 percent, 9.5 percent and 7 percent,
respectively, what is MNINK’s WACC if the firm faces an average tax rate of 34%?
Solution:
Using equation 11-1:
E
P
D
iE 
iP 
iD  1  TC 
EPD
EPD
EPD
 .63  11.60%  .07  9.5%  .30  7%  1  .34 
WACC 
 9.359%
LG3
11-18 TAFKAP Industries has 3 million shares of stock outstanding selling at $17 per
share and an issue of $20 million in 7.5 percent, annual coupon bonds with a
maturity of 15 years, selling at 106 percent of par. If TAFKAP’s weighted average
tax rate is 34 percent and its cost of equity is 14.5 percent, what is TAFKAP’s
WACC?
Solution:
First, solve equation 11-5 for iD:

1


N
1 
1  iD 


Solve PV  PMT 

iD







  PV
 1  i  N
D



1


15
1 
1  iD 


Solve $1,060  $75 

iD





iD  6.8476%



 for iD







  $1, 000  for i
D
 1  i 15 

D




Then, using equation 11-1:
11-8
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
D
iE 
iD  1  TC 
EPD
EPD
3, 000, 000  $17

 14.5%
3, 000, 000  $17  $20, 000, 000  1.06
$20, 000, 000  1.06

 6.8476%  1  .34 
3, 000, 000  $17  $20, 000, 000  1.06
WACC 
 .7064  14.5%  .2936  6.8476%  1  .34 
 11.5694%
LG3
11-19 Johnny Cake Ltd. has 10 million shares of stock outstanding selling at $23 per share
and an issue of $50 million in 9 percent, annual coupon bonds with a maturity of 17
years, selling at 93.5 percent of par. If Johnny Cake’s weighted average tax rate is
34 percent, its next dividend is expected to be $3.00 per share, and all future
dividends are expected to grow at 6 percent per year, indefinitely, what is its
WACC?
Solution:
First, solve equation 11-5 for iD:

1


N
1 
1  iD 


Solve PV  PMT 

iD







  PV
 1  i  N
D



1


17
1 
1

i



D
Solve $935  $90  

iD









$1,
000


for iD
 1  i 17 

D




iD  9.8003%
Next, use equation 11-3 to solve for iE:
iE 
D1
g
P0
$3.00
 .06
$23
 .1904, or 19.04%

Then, using equation 11-1, solve for WACC:
11-9



 for iD



Chapter 11, Solutions
Cornett, Adair, and Nofsinger
E
D
iE 
iD  1  TC 
EPD
EPD
10, 000, 000  $23

 19.04%
10, 000, 000  $23  $50.000, 000  .935
$50.000, 000  .935

 9.8003%  1  .34 
10, 000, 000  $23  $50.000, 000  .935
WACC 
 .8311  19.04%  .1689  9.8003%  1  .34 
 16.9163%
LG4
11-20 BetterPie Industries has 3 million shares of common stock outstanding, 2 million
shares of preferred stock outstanding, and 10 thousand bonds. If the common shares
are selling for $47 per share, the preferred shares are selling for $24.50 per share,
and the bonds are selling for 99 percent of par, what would be the weights used in
the calculation of BetterPie’s WACC?
Solution:
Using the computations for component weights given in equation 11-1:
E
3, 000, 000  $47

E  P  D 3, 000, 000  $47  2, 000, 000  $24.50  10, 000  .99  $1, 000
$141, 000, 000

$199,900, 000
 .7054, or 70.54%
P
2, 000, 000  $24.50

E  P  D 3, 000, 000  $47  2, 000, 000  $24.50  10, 000  .99  $1, 000
$49, 000, 000

$199,900, 000
 .2451, or 24.51%
D
10, 000  .99  $1, 000

E  P  D 3, 000, 000  $47  2, 000, 000  $24.50  10, 000  .99  $1, 000
$9,900, 000

$199,900, 000
 .0495, or 4.95%
LG8
11-21 Suppose that Brown-Murphies’ common shares sell for $19.50 per share, are
expected to set their next annual dividend at $.57 per share, and that all future
dividends are expected to grow by 4 percent per year, indefinitely. If BrownMurphies faces a flotation cost of 13% on new equity issues, what will be the
flotation-adjusted cost of equity?
Solution:
Using equation 11-8:
11-10
Chapter 11, Solutions
iE 

Cornett, Adair, and Nofsinger
D1
g
P0  F
$.57
 .04
$19.50  .13  $19.50 
 .0736, or 7.36%
Advanced Problems
LG2
11-22 A firm is considering a project that will generate perpetual after-tax cash flows of
$15,000 per year beginning next year. The project has the same risk as the firm's
overall operations and must be financed externally. Equity flotation costs 14% and
debt issues cost 4% on an after-tax basis. The firm's D/E ratio is 0.8. What is the
most the firm can pay for the project and still earn its required return?
Solution:
If the D/E ratio is 0.8, then D/(D+E) will be 0.8/1.8 = .4444 and E/(D+E) will be
1.0/1.8 = .5556.
Then, using equation 11-1, solve for WACC:
E
D
iE 
iD  1  TC 
EPD
EPD
 .5556  14%  .4444  4%
 9.5556%
WACC 
LG2
11-23 A firm has 5,000,000 shares of common stock outstanding, each with a market price
of $8.00 per share. It has 25,000 bonds outstanding, each selling for $800. The
bonds mature in 10 years, have a coupon rate of 8%, and pay coupons semiannually. The firm’s equity has a beta of 1.4, and the expected market return is
15%. The tax rate is 35% and the WACC is 15%. Calculate the risk free rate.
Solution:
First, solve equation 11-5 for iD:
11-11
Chapter 11, Solutions
Cornett, Adair, and Nofsinger

1

1


N

1  iD 


Solve PV  PMT 

iD







  PV
 1  i  N
D





 for iD




1


20
1 
1  iD 


Solve $800  $40 

iD





iD  5.7017%  2  11.4034%




  $1, 000  for i
D
 1  i 20 

D




Then solve equation 11-1 for iE:
E
D
iE 
iD  1  TC 
EPD
EPD
5, 000, 000  $8.00
25, 000  $800
15% 
iE 
 11.
5, 000, 000  $8.00  0  25, 000  $800
5, 000, 000  $8.00  0  25, 000  $800
WACC 
15%  .6667  iE  .3333  11.4034%  1  .35 
15%  .6667  iE  2.4707%
12.5293%  .6667  iE
12.5293%
 iE
.6667
18.7939%  iE
Finally, putting this into equation 11-6 and solving for the risk-free rate:
iE  rf   Avg  E  rM   rf 
18.7939%  rf  1.4 15%  rf 
18.7939%  rf  21%  1.4rf
.4rf  21%  18.7939%
.4rf  2.2061%
2.2061%
.4
rf  5.5153%
rf 
11-12
Chapter 11, Solutions
LG6
Cornett, Adair, and Nofsinger
11-24 An all-equity firm is considering the projects shown below. The T-bill rate is 4
percent and the market risk premium is 7 percent. If the firm uses its current WACC
of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly
rejected?
Project Expected Return Beta
A
8.0%
0.5
B
19.0%
1.2
C
13.0%
1.4
D
17.0%
1.6
Solution:
Using the firm’s WACC of 12 percent as the IRR benchmark, project A would be
rejected. Using equation 11-2, the project-specific benchmarks for each project
should be:
For Project A: iE  i f   E  E  iM   i f 
 4%  0.5  7% 
 7.5%
For Project B: iE  i f   E  E  iM   i f 
 4%  1.2  7% 
 12.4%
For Project C: iE  i f   E  E  iM   i f 
 4%  1.4  7% 
 13.8%
For Project D: iE  i f   E  E  iM   i f 
 4%  1.6  7% 
 15.2%
If Project A’s expected return of 8% had been compared to the project-specific
required return of 7.5%, it would have been accepted. Therefore, Project A would
have been incorrectly rejected if the firm-wide WACC had been used as its
benchmark.
LG6
11-25 An all-equity firm is considering the projects shown below. The T-bill rate is 4
percent and the market risk premium is 7 percent. If the firm uses its current WACC
of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly
accepted?
11-13
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
Project Expected Return Beta
A
8.0%
0.5
B
19.0%
1.2
C
13.0%
1.4
D
17.0%
1.6
Solution:
Using the firm’s WACC of 12 percent as the IRR benchmark, projects B, C and D
would be accepted. Using equation 11-2, the project-specific benchmarks for each
project should be:
For Project A: iE  i f   E  E  iM   i f 
 4%  0.5  7% 
 7.5%
For Project B: iE  i f   E  E  iM   i f 
 4%  1.2  7% 
 12.4%
For Project C: iE  i f   E  E  iM   i f 
 4%  1.4  7% 
 13.8%
For Project D: iE  i f   E  E  iM   i f 
 4%  1.6  7% 
 15.2%
If Project C’s expected return of 13% had been compared to the project-specific
required return of 13.8%, it would have been rejected. Therefore, Project C would
have been incorrectly accepted if the firm-wide WACC had been used as its
benchmark.
LG7
11-26 Suppose your firm has decided to use a divisional WACC approach to analyze
projects. The firm currently has 4 divisions, A through D, with average betas for
each division of 0.6, 1.0, 1.3 and 1.6, respectively. If all current and future projects
will be financed with half debt and half equity, and if the current cost of equity
(based on an average firm beta of 1.0 and a current risk-free rate of 7 percent) is 13
percent and the after-tax yield on the company’s bonds is 8 percent, what will the
WACCs be for each division?
Solution:
Using equation 11-2, we can solve for the expected rate of return on the market:
11-14
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
iE  i f   E  E  iM   i f 
13%  7%  1.0  E  iM   7% 
6%   E  iM   7% 
13%  E  iM 
Reusing equation 11-2, we can solve for the divisional costs of equity using the
average divisional betas:
For Division A: iE  i f   E  E  iM   i f   7%  0.6  13%  7%   10.6%
For Division B: iE  i f   E  E  iM   i f   7%  1.0  13%  7%   13%
For Division C: iE  i f   E  E  iM   i f   7%  1.3  13%  7%   14.8%
For Division D: iE  i f   E  E  iM   i f   7%  1.6  13%  7%   16.6%
Finally, we can solve for the divisional WACCs using equation 11-1:
E
iE
EPD
E
For Division B: WACC 
iE
EPD
E
For Division C: WACC 
iE
EPD
E
For Division D: WACC 
iE
EPD
For Division A: WACC 
D
iD  1  TC   .5  10.6%  .5  8%  9.3%
EPD
D

iD  1  TC   .5  13%  .5  8%  10.5%
EPD
D

iD  1  TC   .5  14.8%  .5  8%  11.4%
EPD
D

iD  1  TC   .5  16.6%  .5  8%  12.3%
EPD

Research It! (Web-Exercises): Finding the Before-Tax Cost of Debt, iD
For component debt costs, we’d like to use the yield to maturity on bonds that resemble the
maturity of our potential debt as possible. Let’s assume that we want to find a bond issue
with approximately 10 years until maturity (as of January, 2007) for Bear Stearns. Luckily,
Bear Stearns has quite a few outstanding bond issues to choose from, and we can access the
information on these issues on the Yahoo! Finance page. Go to http://finance.yahoo.com/
and start by clicking on “Investing” and then “Bonds” as shown to the right:
Then enter Bear Stearns in the “Bond Lookup” box and click on “Search” as shown below:
You’ll be presented with a list of Bear Stearns’ outstanding bonds sorted in order of
decreasing maturity:
Once you’ve identified the bond with the maturity closest to the maturity you want, click on
the “Issue” entry and look up the Yield to Maturity.
Your turn: go to the Yahoo! Finance web site and find the YTM on the bond with a maturity
that’s as close as possible to 10 years from today’s date.
11-15
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
Integrated Minicase: WACC for a New Project
LilyMac Studios, a national chain of photography studios, is considering opening up a chain
of coffee shop/art galleries. While the existing operations of the firm have a beta of 1.17,
the new chain is expected to have a beta of 0.8.
LilyMac currently has 500,000 shares of common stock outstanding, which are selling for
$63.72 per share, and a $10 million dollar bond issue, selling at 104 percent of par. The
expected market risk premium is 6 percent, and the current risk-free rate is 5.5%. The
bonds pay an 8 percent semiannual coupon and mature in 20 years.
LilyMac’s next expected dividend is $4.00 per share, and future dividends are expected to
grow at 4% per year.
The current operations of the firm produce EBIT of $18 million per year, and the chain’s
operations are expected to add only $25 million per year to that. The new chain will be
funded with 65% percent equity and 35% debt, and estimated flotation costs are expected to
be 12 percent and 5 percent, respectively.
What should be the WACC for the new chain of coffee shops?
Solution:
Using the constant growth formula along with the flotation cost of equity, 12 percent
of $63.72 will be $7.64, so the cost of equity will be equal to:
iE 
D1
g
P0  F
$4.00
 .04
$63.72  $7.65
 .1113,or 11.13%

Notice that, without the flotation cost, this would be:
iE 
D1
g
P0
$4.00
 .04
$63.72
 .1028,or 10.28%

Which is an increase of 11.13% - 10.28% = .86% due to the flotation cost, so if we
use the CAPM approach, the cost of equity will be equal to:
11-16
Chapter 11, Solutions
Cornett, Adair, and Nofsinger
iE  rf   E ,Pr oject  E  rM   rf 
 .055  0.8 .06
 .103, or 10.3%
Which would be similarly adjusted to 10.3% + .86% = 11.16%. Taking an average
of the two costs of equity, we will use (11.13% + 11.16%)/2 = 11.145%.
The YTM on the new bonds issued to finance this project will be:

1





1  1  i 40 

$1000 

D


Solve $1,040- .05*$1,040   $40 

 for iD

 1  iD 40 
iD







Which gives us an annual iD of 8.1224%.
Finally, the current EBIT puts the firm in the 38% tax bracket, so the additional
EBIT generated by the project will be taxed at an average marginal tax rate of:
Which gives us an after-tax cost of debt of 8.1224%×(1-.3504)=5.2763%
Using these component costs for equity and debt, and taking the capital structure of
the new chain, we get a WACC of:
11-17