Suppose the project described in Problem 17 is to be undertaken by a university. Funds for the project will be withdrawn from the university€™s endowment, which is invested in a widely diversified portfolio of stocks and bonds. However, the university can also borrow at 7%. The university is tax exempt.
The university treasurer proposes to finance the project by issuing $400,000 of perpetual bonds at 7% and by selling $600,000 worth of common stocks from the endowment. The expected return on the common stocks is 10%. He therefore proposes to evaluate the project by discounting at a weighted-average cost of capital, calculated as:

What€™s right or wrong with the treasurer€™s approach? Should the university invest? Should it borrow? Would the project€™s value to the university change if the treasurer financed the project entirely by selling common stocks from theendowment?

D E 400,000 1,000,000 +.10 600,000 = .088, or 8.8