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3. That is, the firm may be able to finance $3.6 million in new investments with internal common stock and
debt without having to change the current mix of 50 percent debt and 50 percent common stock. Therefore,
if the total financing is $3.6 million or less, the firmâ€™s cost of capital is 10 percent.
4. Construct the MCC schedule on the 1 0 s graph to determine the discount rate to be used in order to decide
in which project to invest and to show the firmâ€™s optimal capital budget. See Fig. 101.
The firm should continue to invest up to the point where the IRR equals the MCC. From the graph in Fig. 101,
note that the firm should invest in projects B and A, since each IRR exceeds the marginal cost of capital. The firm
should reject project C since its cost of capital is greater than the IRR. The optimal capital budget is $4 million,
since this is the sum of the cash outlay required for projects A and B.
287
COST OF CAPITAL
CHAP, 101
t

9  'IRR
 o    o  ˜
ti
C
L 8
Do 
L
2
a
s
..
L
4:
"
w
I
I
v
10s graph
Fig. 101 MCC schedule and
Review Questions
of the costs of the various types of
1. The firm's cost of capital is calculated as a(n)
financing.
2. Capital components on the righthand side of the firm's balance sheet are 9
, and
3. There are three techniques for measuring the cost of common stock. They are 9
, and
, is used in: (1) making
The cost of capital, often called the
4.
decisions; (2) helping to establish the ; and (3) making such decisions as
,bond financing, and working capital management.
5. The aftertax cost of debt is ki times
6. The is found by dividing the annual dividend by the
net proceeds from sale.
7. No tax adjustments are necessary for the computation of the costs of and
preferred stock.
8. The cost of is higher than the cost of common stock because of
involved in its sale.
9. The approach to determining the cost of common stock is to add a
to the firm's own cost of longterm debt.
10. Two types of historical weights are used: and
COST OF CAPITAL
288 [CHAP. 10
11. In computing the firmâ€™s overall cost of capital, the weights that can b2 used are 9
, and
schedule shows the weighted cost of capital for each level of total new
12. The
financing.
13. The comparison of the and the helps determine the firmâ€™s
to be used in the capital budgeting process.
, the cost of common equity is a function of the riskfree rate,
14. Using the
, and the market return.
, the cost of common equity is dividend yield plus
15. Using the
Answers: (1) weighted average; (2) longterm debt, preferred stock, common stock, retained earnings; (3) the
Gordonâ€™s growth model approach, the CAPM approach, the bond plus approach; (4) required rate of return, capital
budgeting, optimal capital structure, leasing; (5) (1  tax rate); (6) cost of preferred stock, preferred stock; (7)
common stock (equity); (8) new common stock, flotation costs; (9) bond plus, risk premium; (10) book value, market
value; (11) historical, target, marginal; (12) marginal cost of capital (MCC); (13) MCC, investment opportunity
schedule (IOS), optimal capital budget; (14) CAPM, beta; (15) Gordonâ€™s growth model, growth rate in earnings
and dividends.
Solved Problems
Cost of Debt. Calculate the aftertax cost of debt under each of the following cases: ( a ) the
10.1
interest rate is 10 percent, and the tax rate is 40 percent; ( b ) the interest rate is 11 percent,
and the tax rate is 50 percent.
SOLUTION
ki(1  t )
kd =
10% (1  0.4) = 6%
=
kd
= 11% (1  0.5) = 5.5%
kd
1.
02 Cost of Bonds. XYZ Company has bonds outstanding with 7 years left before maturity. The bonds
are currently selling for $800 per $1,000face value. The interest is paid annually at a rate of 12
ñòð. 137 