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SOLUTION TO INTEGRATIVE CASE PROBLEM: COST OF CAPITAL

1. Cost of debt: ki = 9%(1 - 0.4) = 5.4% for the first $50 million ki = 10%(1 - 0.4) = 6% for debt exceeding $50 million. Cost of equity: (g = 7.2% using the Rule of 72) ke = $1.415/$21 + .072 = .139 or 13.9% for internal equity ke' = $1.415/$19 + .072 = .146 or 14.6% for external equity

2. Size of first interval: $50 million first mortgage bonds/0.40 = $125 million. (Balance of first block of funds is retained earnings with a cost of 13.9%. Debt cost is 5.4%). ka = 0.4(5.4%) + 0.6(13.9%) = 10.50%

Size of second interval: $25 million retained earnings/0.60 = $41.67 million. (Balance of second block of funds is debt with a 6% cost. Cost of retained earnings is 13.9%). ka = 0.4(6%) + 0.6(13.9%) = 10.74%

Size of third interval: $75 million new common stock/0.60 = $125 million (Balance of third block of funds is debt at a cost of 6%. Equity cost is 14.6%). ka = 0.4(6%) + 0.6(14.6%) = 11.16%

MCC curve: $0 - $125 MM 10.50% $125 MM - $166.67 MM 10.74% $166.67 MM - $291.67 MM 11.16%

3. Projects A through F require $175 million and have returns in excess of the marginal cost of capital.

4. Project G should be rejected because it offers a 10% rate of return and the cost of the funds needed to finance it is 11.16%.

5. If the projects differed substantially in risk, an alternative capital budget might be proposed. Also, it is possible that the firm would be unwilling to raise external equity capital (and thus dilute the ownership interest of current stockholders).

6. a. Cost of debt: ki = 11%(1 - 0.4) = 6.6% for the first $50 million ki = 12.5%(1 - 0.4) = 7.5% for debt exceeding $50 million. Cost of equity: (g = 7.2% using the

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