Chapter 8
1.
a. Debt/Equity ratio in book value; Debt/Equity ratio in market value
𝐷𝑒𝑏𝑡 $2,500,000,000
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑖𝑛 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = = = 100%
𝐸𝑞𝑢𝑖𝑡𝑦 $2,500,000,000
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 = 0.8 × $2,500,000,000 =
$2,000,000,000 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 50,000,000 ×
$80 = $4,000,000,000
𝐷𝑒𝑏𝑡 $2,000,000,000
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 = = = 50%
𝐸𝑞𝑢𝑖𝑡𝑦 $4,000,000,000
b. Debt/Debt + Equity ratio in book value; Debt/Debt + Equity ratio in market value
𝐷𝑒𝑏𝑡 $2,500,000,000
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐷𝑒𝑏𝑡 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑖𝑛 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 = =
= 50%
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦$5,000,000,000
𝐷𝑒𝑏𝑡 $2,000,000,000
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐷𝑒𝑏𝑡 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 𝑖𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 =
= = 33.3% 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 $6,000,000,000 c. After-
tax cost of debt
𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 0.12 × (1 − 0.4)
= 7.2% d. Cost of equity
𝑟𝑒 = 𝑟𝑓 + 𝛽 × 𝐸𝑅𝑃 = 0.08 + 1.2 × 0.055 =
14.6% e. Cost of capital
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = (𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 × 𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡) + (𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
× 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦)
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦
=( × 𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡) + ( × 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦)
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦
$2,000,000,000 $4,000,000,000
=( × 0.072) + ( × 0.146) = 12.13%
$6,000,000,000 $6,000,000,000
2. a. To assess this project from the equity investors' standpoint, we estimate cash
flows to equity and the cost of equity.
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 = 𝑊𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 × 𝐼𝑛𝑖𝑡𝑖𝑎𝑙
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
$4,000,000,000
= × $100,000,000 = $66,670,000
$6,000,000,000
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑡𝑖𝑎𝑡𝑖𝑜𝑛 = $9,600,000 +
$5,000,000 = $14,600,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 14.6%
𝐶𝐹
𝑁𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 +
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
$14,600,000
= −$66,670,000 + = $33,330,000
0.146
b. From the firm's standpoint, the cash flows to the firm have to be estimated
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑃𝑟𝑜𝑗𝑒𝑐𝑡 = $100,000,000
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐹𝑖𝑟𝑚 = 𝐸𝐵𝐼𝑇(1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑡𝑖𝑎𝑡𝑖𝑜𝑛
= $20,000,000 × (1 − 0.4) + $5,000,000 = $17,000,000
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 12.13%
𝐶𝐹
𝑁𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑡𝑜 𝐹𝑖𝑟𝑚 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 +
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
$17,000,000
= −$100,000,000 + = $40,150,000
0.1213
c. The cost of equity should be used as the discount rate if the cash flows being
discounted are cash flows to equity.
d. The cost of capital should be used as the discount rate if the cash flows being
discounted are cash flows to the firm.
e. Even if this project is financed entirely with debt, it should be analyzed using the
same costs of equity and capital as the analysis above.
3.