CHAPTER 13
RISK, COST OF CAPITAL, AND
CAPITAL BUDGETING
Answers to Concepts Review and Critical Thinking Questions
1. No. The cost of capital depends on the risk of the project, not the source of the money.
2. Interest expense is tax-deductible. There is no difference between pretax and aftertax
equity costs.
3. You are assuming that the new project’s risk is the same as the risk of the firm as a whole,
and that the firm is financed entirely with equity.
10. Beta measures the responsiveness of a security's returns to movements in the market. Beta
is determined by the cyclicality of a firm's revenues. This cyclicality is magnified by the
firm's operating and financial leverage. The following three factors will impact the firm’s
beta. (1) Revenues. The cyclicality of a firm's sales is an important factor in determining
beta. In general, stock prices will rise when the economy expands and will fall when the
economy contracts. As we said above, beta measures the responsiveness of a security's
returns to movements in the market. Therefore, firms whose revenues are more responsive
to movements in the economy will generally have higher betas than firms with
less-cyclical revenues. (2) Operating leverage. Operating leverage is the percentage
change in earnings before interest and taxes (EBIT) for a percentage change in sales. A
firm with high operating leverage will have greater fluctuations in EBIT for a change in
sales than a firm with low operating leverage. In this way, operating leverage magnifies
the cyclicality of a firm's revenues, leading to a higher beta. (3) Financial leverage.
Financial leverage arises from the use of debt in the firm's capital structure. A levered firm
must make fixed interest payments regardless of its revenues. The effect of financial
leverage on beta is analogous to the effect of operating leverage on beta. Fixed interest
payments cause the percentage change in net income to be greater than the percentage
change in EBIT, magnifying the cyclicality of a firm's revenues. Thus, returns on
highly-levered stocks should be more responsive to movements in the market than the
returns on stocks with little or no debt in their capital structure.
Solutions to Questions and Problems
1. With the information given, we can find the cost of equity using the CAPM. The cost of
equity is:
RS = .038 + 1.17(.11 – .038)
RS = .1222, or 12.22%
5. Using the equation to calculate the WACC, we find:
RWACC = .70(.115) + .30(.059)(1 – .35)
RWACC = .0920, or 9.20%
8. a. The book value of equity is the book value per share times the number of shares, and
the book value of debt is the face value of the company’s debt, so:
Equity = 8,300,000($4) = $33,200,000
Debt = $70,000,000 + 60,000,000 = $130,000,000
So, the total book value of the company is:
Book value = $33,200,000 + 130,000,000 = $163,200,000
And the book value weights of equity and debt are:
Equity/Value = $33,200,000/$163,200,000 = .2034
Debt/Value = 1 – Equity/Value = .7966
b. The market value of equity is the share price times the number of shares, so:
S = 8,300,000($53) = $439,900,000
Using the relationship that the total market value of debt is the price quote times the
par value of the bond, we find the market value of debt is:
B = 1.083($70,000,000) + 1.089($60,000,000) = $141,150,000
This makes the total market value of the company:
V = $439,900,000 + 141,150,000 = $581,050,000
And the market value weights of equity and debt are:
S/V = $439,900,000/$581,050,000 = .7571
B/V = 1 – S/V = .2429
c. The market value weights are more relevant.
9. First, we will find the cost of equity for the company. The information provided allows us
to solve for the cost of equity using the CAPM, so:
RS = .037 + 1.15(.07)
RS = .1175, or 11.75%
Next, we need to find the YTM on both bond issues. Doing so, we find:
P1 = $1,083 = $35(PVIFAR%,16) + $1,000(PVIFR%,16)
R = 2.847%
YTM = 2.847% × 2 = 5.69%
P2 = $1,089 = $37.50(PVIFAR%,54) + $1,000(PVIFR%,54)
R = 3.389%
YTM = 3.389% × 2 = 6.78%
To find the weighted average aftertax cost of debt, we need the weight of each bond as a
percentage of the total debt. We find:
XB1 = 1.083($70,000,000) / $141,150,000 = .537
XB2 = 1.089($60,000,000) / $141,150,000 = .463
Now we can multiply the weighted average cost of debt times one minus the tax rate to
find the weighted average aftertax cost of debt. This gives us:
RB = (1 – .35)[(.537)(.0569) + (.463)(.0678)]
RB = .0403, or 4.03%
Using these costs and the weight of debt we calculated earlier, the WACC is:
RWACC = .7571(.1175) + .2429(.0403)
RWACC = .0987, or 9.87%
13. a. Projects Y and Z.
b. Using the CAPM to consider the projects, we need to calculate the expected return of
each project given its level of risk. This expected return should then be compared to
the expected return of the project. If the return calculated using the CAPM is lower
than the project expected return, we should accept the project; if not, we reject the
project. After considering risk via the CAPM:
E[W] = .035 + .80(.11 – .035) = .0950 > .094, so reject W
E[X] = .035 + .95(.11 – .035) = .1063 < .109, so accept X
E[Y] = .035 + 1.15(.11 – .035) = .1213 < .13, so accept Y
E[Z] = .035 + 1.45 (.11 – .035) = .1438 > .142, so reject Z
c. Project X would be incorrectly rejected; Project Z would be incorrectly accepted.
16. Using the debt–equity ratio to calculate the WACC, we find:
RWACC = (.65 / 1.65)(.055) + (1 / 1.65)(.13)
RWACC = .1005, or 10.05%
Since the project is riskier than the company, we need to adjust the project discount rate
for the additional risk. Using the subjective risk factor given, we find:
Project discount rate = 10.05% + 2%
Project discount rate = 12.05%
We would accept the project if the NPV is positive. The NPV is the PV of the cash
outflows plus the PV of the cash inflows. Since we are seeking the breakeven initial cost,
we just need to find the PV of future inflows. The cash inflows are a growing perpetuity. If
you remember, the equation for the PV of a growing perpetuity is the same as the dividend
growth equation, so:
PV of future CF = $2,900,000 / (.1205 – .04)
PV of future CF = $36,045,198
The project should only be undertaken if its cost is less than $36,045,198 since a cost less
than this amount will result in a positive NPV.
