Section Two: Answers

Part 1 Cost of Capital Basses

Introduction to Cost of Capital Applications: Valuation and Project Selection

1. a. Some use net income, but Ibbotson rate of return data are sped fically matched to net cash flow.

2. c

3. b. If return to equily is being discounted, the rate would be the equity discount rate, if re­turn to the overall capital structure is being discounted, the rate would be the weighted av­erage cost of capital.

4. True

5. True

6. Free cas

7. Capitalization rate

8. PV =

Interest at end of year 1

$70 (1 + 0.10) $70 (U0) $63.64 $907.00

Interest at end of year 2

$70 (1 + 0.10)' $70 (L21) $57.85

Interest at end of year 3

$70 (1 + 0.10)3 $70 033) $52.63

Interest at end of year 4

$1070 (1 + 0.10)4 $1070 (1-46) $732.88

Alternatively, this may be computed by factors times dollars to be received:

Factor for year 1:1/1.10 = 1A909 = 0.909 Factor for year 2: 1/(1.10)2 = 1/1-21 = 0.826 Factor for year 3: 1/(1.1.0)3 = 1/133 = 0.752 Factor for year 4: 1/(1.10)4 = 1/1.46 = 0.685

Year 1: 0.909 x $70 = $63.63 Year 2: 0.826 x $70 = 57.82 Year 3: 0.752 x $70 = 52.64 Year 4: 0.685 x $1070 = $732.95 $907.04 (Differences are due to rounding.)

9. The company's embedded cost of capital for this bond is 7%. That is what they actually will pay over the life of the bond.

10. The company's market cost of capital for tills bond is 10%. That is what they would have to pay if they were to issue comparable bonds at the valuation date.

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