In the course of discussing the fiber-optic blood pressure monitor project that we introduced in Chapter 10, a recently hired financial analyst who is working on her MBA asks how the company arrived at 9.5 % as the discount rate to use when evaluating capital budgeting projects. Her question is followed by an embarrassing silence that seems to last forever. Eventually, the comptroller, who has been with the company for many years, offers an explanation. When the company first began to use discounted cash flow methods for capital budgeting decisions in the 1980s, it hired a consultant to explain internal rate of return and net present value. The consultant used 10.5 % in all his examples, so BioCom did the same. By the late 1990s, interest rates had fallen considerably, and the company was rejecting some seemingly profitable projects because the hurdle rate was too high, so it lowered it to 9.5 % As far as he knew, that was the end of the story.

Interestingly, many participants in the discussion—even those who are not from accounting and finance—are aware of the weighted average cost of capital and have a good idea of how to compute it, but no one had ever attempted to do so for BioCom. After a brief discussion, they ask the person who raised the question in the first place to analyze the company's debt and equity and report back in a week with her estimate of the company's weighted average cost of capital.  

She begins by gathering the following information: BioCom has two outstanding bond issues. Bond 1 matures in six years, has a par value of $1,000, has a coupon rate of 7.6 % paid semiannually, and now sells for $1,031.85. Bond 2 matures in sixteen years, has a par value of $1,000, has a coupon rate of 8.4% paid semiannually, and now sells for $1,034.25.

The preferred stock has a par value of $50, pays a dividend of $1.521.52, and has a current market value of $19.15. The common stock sells for $35.45 per share and recently paid a dividend of$2.552.55. The company expects dividends to grow at an average annual rate of 6.2% for the foreseeable future. The risk-free rate is 3.2%, the expected rate of return on the market portfolio is 12.3%, BioCom's beta is 1.25, and its marginal tax rate is 34%.

BioCom's capital structure is shown in the popup window:

Type of Capital	Percent of Book Value		Percent of Market Value
Bond 1	20%		17%
Bond 2	22%		19%
Preferred stock	21%		12%
Common stock	7%		Not available
Retained earnings	30%		Not available
Total common equity			52%

Assist the financial analyst by answering these questions.

Questions

1.  Compute the yield to maturity and the after-tax cost of debt for the two bond issues.

2.  Compute BioCom's cost of preferred stock.

3.  Compute BioCom's cost of common equity. Use the average of results from the dividend growth model and the security market line.

4.  Compute BioCom's weighted average cost of capital. Should you use book values or market values for this computation?

5.  BioCom could sell new bonds with maturities of twenty years at approximately the same yield as bond 2. It would, however, incur flotation costs of

$15 per $1,000 of par value. Estimate the effective interest rate BioCom would have to pay on a new issue of long-term debt.

6.  Some of BioCom's projects are low risk, some average risk, and some high risk. Should BioCom use the same cost of capital to evaluate all its projects, or should it adjust the discount rate to reflect different levels of risk?

Answer rating: 100% (QA)

1 Yield to maturity of both bonds can be calculated in excel as After tax cost debt of Bond 1 6941034 458 After tax cost of Bond 2 8021034 529 2 Divid... View the full answer