Principles Of Managerial Finance 13th Edition By Gitman – Test Bank

Answers to Warm-Up Exercises

E9-1.          Weighted average cost of capital

Answer:     N = 10, PV = $20,000 (1 – 0.02) = $19,600, PMT = -0.08 ´ $20,000 = -$1,600, FV = -$20,000

                  Solve for I = 8.30%

E9-2.          Cost of preferred stock

Answer:    The cost of preferred stock is the ratio of the preferred stock dividend to the firm’s net proceeds from the sale of the preferred stock.

r_p = D_p ¸ N_p

r_p = (0.15 ´ $35) ¸ ($35 – $3)

r_p = $5.25 ¸ $32 = 16.4%

E9-3.         Cost of common stock equity

Answer:    The cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current price of the stock and adding the expected growth rate.

r_s = (D₁ ¸ P₀) + g

r_s = ($6.50 ¸ $78) + 7% = 15.33%

E9-4.        Weighted average cost of capital

Answer:   r_a = (0.35 ´ 0.08) + (0.65 ´ 0.13) = 0.0280 + 0.0845 = 11.25%

E9-5.         Weighted average cost of capital

Answer:    r_a = (0.55 ´ 0.067) + (0.10 ´ 0.092) + (0.35 ´ 0.106) = 0.0832 = 8.32%

n Solutions to Problems

P9-1.     Concept of cost of capital

LG 1; Basic

1. The firm is basing its decision on the cost to finance a particular project rather than the firm’s combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions.
2. r_a = w_d r_d + w_e r_e

r_a = 0.40 (7%) + 0.60(16%)

r_a = 2.8% + 9.6%

r_a = 12.4%

263. Reject project 263. Accept project 264.
264. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as a criterion provides better decisions because it takes into consideration the long-run interrelationship of financing decisions.

P9-2.     Cost of debt using both methods

LG 3; Intermediate

1. Net proceeds: N_d = $1,010 – $30

N_d = $980

1. Cost to maturity:

N = 15, P = 980, PMT = -120, FV = -1,000

Solve for I: 12.30%

After-tax cost: 12.30% (1 – 0.4) = 7.38%

1. Approximate before-tax cost of debt

r_d = $121.33 ¸ $990,000

r_d = 12.26%

Approximate after-tax cost of debt = 12.26% ´ (1 – 0.4) = 7.36%

1. The advantages of the calculator method are evident. There are fewer keypunching strokes and one gets the actual cost of debt financing. However, the approximation formula is fairly accurate and expedient in the absence of a financial calculator.

P9-3.     Before-tax cost of debt and after-tax cost of debt

LG 3; Easy

1. N = 10, PV = – 930 (an expenditure), PMT = 0.6(1,000) = 60, FV = 1,000

Solving for I = 7.00%

1. Use the model: After-tax cost of debt = before-tax cost of debt ´ (1 – tax bracket)

7.0% (1 – 0.2) = 5.6%

P9-4.     Cost of debt using the approximation formula:

LG 3; Basic

r_i = r_d ´ (1 – T)

Bond A

r_i = 9.44% ´ (1 – 0.40) = 5.66%

Bond B

r_i = 10.34% ´ (1 – 0.40) = 6.20%

Bond C

r_i = 12.58% ´ (1 – 0.40) = 7.55%

Bond D

r_i = 9.13% ´ (1 – 0.40) = 5.48%

Bond E

r_i = 11.84% ´ (1 – 0.40) = 7.10%

P9-5.     Cost of debt using the approximation formula

LG 3; Intermediate

r_i = r_d ´ (1 – T)

Alternative A

r_i = 6.87% ´ (1 – 0.40) = 4.12%

Calculator: N = 16, PV = $1,220, PMT = -$90, FV = -$1,000

Solve for I: 6.71%

After-tax cost of debt: 4.03%

Alternative B

r_i = 6.54% ´ (1 – 0.40) = 3.92%

Calculator: N = 5, PV = $1,020, PMT = -$70, FV = -$1,000

Solve for I: 6.52%

After-tax cost of debt: 3.91%

Alternative C

r_i = 6.53% ´ (1 – 0.40) = 3.92%

Calculator: N = 7, PV = $970, PMT = -$60, FV = -$1,000

Solve for I: 6.55%

After-tax cost of debt: 3.93%

Alternative D

r_i = 6.39% ´ (1 – 0.40) = 3.83%

Calculator: N = 10, PV = $895, PMT = -$50, FV = -$1,000

Solve for I: 6.46%

After-tax cost of debt: 3.87%

P9-6.     After-tax cost of debt

LG 3; Intermediate

1. Since the interest on the boat loan is not tax deductible, its after-tax cost equals its stated cost of 8%.
2. Since the interest on the second mortgage is tax deductible, its after-tax cost is found by multiplying the before-tax cost of debt by (1 – tax rate). Being in the 28% tax bracket, the after-tax cost of debt is 6.6% = 9.2% ´ (1 – 0.28).
3. Home equity loan has a lower after-tax cost. However, using the second home mortgage does put the Starks at risk of losing their home if they are unable to make the mortgage payments.

P9-7.     Cost of preferred stock: r_p = D_p ¸ N_p

LG 2; Basic

P9-8.     Cost of preferred stock: r_p = D_p ¸ N_p

LG 4; Basic

P9-9.     Cost of common stock equity—capital asset pricing model (CAPM)

LG 5; Intermediate

r_s = R_F + [b ´ (r_m – R_F)]

r_s = 6% + 1.2 ´ (11% – 6%)

r_s = 6% + 6%

r_s = 12%

1. Risk premium = 6%
2. Rate of return = 12%
3. After-tax cost of common equity using the CAPM = 12%

P9-10.    Cost of common stock equity:

LG 5; Intermediate

2. N = 4 (2012 – 2008), PV (initial value) = -$2.12, FV (terminal value) = $3.10

Solve for I (growth rate): 9.97%

1. N_n = $52 (given in the problem)
2. r_r = (Next Dividend ¸ Current Price) + growth rate

r_r = ($3.40 ¸  $57.50) + 0.0997

r_r = 0.0591 + 0.0997 = 0.1588 or 15.88%

3. r_r = ($3.40 ¸ $52) + 0.0997

r_r = 0.0654 + 0.0997 = 0.1651 or 16.51%