CHAPTER 9 THE COST OF CAPITAL

(Difficulty: E = Easy, M = Mediu , a!d T = T"u#$%

Multi&le C$"ice: P'"(le s Easy:

Cost of common stock Answer: d Diff: E 1 . Bouchard Company's stock sells for $20 per share, its last dividend (D 0 !as $1.00, and its "ro!th rate is a constant # percent. $hat is its cost of common stock, rs% a. &.0' (. &.)' c. 11.0' d. 11.)' e. 11.#' Cost of common stock Answer: b Diff: E 2 . *our company's stock sells for $&0 per share, its last dividend (D 0 !as $2.00, and its "ro!th rate is a constant & percent. $hat is the cost of common stock, rs% a. +.0' (. +.2' c. +.#' d. +.,' e. 10.0' Cost of common stock Answer: e Diff: E ) . -he .lo(al /dvertisin" Company has a mar"inal ta0 rate of 10 percent. -he last dividend paid (y .lo(al !as $0.+0. .lo(al's common stock is sellin" for $,.&+ per share, and its e0pected "ro!th rate in earnin"s and dividends is & percent. $hat is .lo(al's cost of common stock% a. (. c. d. e. 12.22' 12.22' 10.))' +.##' 1#.00'

Chapter 9 - Page 1

WACC with Flotation Costs 1 . /n analyst has Christopher Co.3

collected

the

follo!in"

Answer: a Diff: E information re"ardin"

-he company4s capital structure is 20 percent e5uity, )0 percent de(t. -he yield to maturity on the company4s (onds is + percent. -he company4s year6end dividend is forecasted to (e $0.,0 a share. -he company e0pects that its dividend !ill "ro! at a constant rate of + percent a year. -he company4s stock price is $2&. -he company4s ta0 rate is 10 percent. -he company anticipates that it !ill need to raise ne! common stock this year. 7ts investment (ankers anticipate that the total flotation cost !ill e5ual 10 percent of the amount issued. /ssume the company accounts for flotation costs (y ad8ustin" the cost of capital. .iven this information, calculate the company4s $/CC. 10.11' 12.&#' 10.2,' 1).&&' +.2+'

a. (. c. d. e.

Medium:
WACC & . Answer: d Diff: M / company4s (alance sheets sho! a total of $)0 million lon"6term de(t !ith a coupon rate of + percent. -he yield to maturity on this de(t is 11.11 percent, and the de(t has a total current market value of $2& million. -he (alance sheets also sho! that that the company has 10 million shares of stock9 the total of common stock and retained earnin"s is $)0 million. -he current stock price is $2.& per share. -he current return re5uired (y stockholders, r:, is 12 percent. -he company has a tar"et capital structure of 10 percent de(t and #0 percent e5uity. -he ta0 rate is 10'. $hat !ei"hted avera"e cost of capital should you use to evaluate potential pro8ects% a. ,.&&' (. +.))' c. +.)#' d. +.,2' e. 10.#2'

Chapter 9 - Page 2

Cost of common stock Answer: d Diff: M # . -he common stock of /nthony :teel has a (eta of 1.20. -he risk6free rate is & percent and the market risk premium (r; 6 r<= is # percent. $hat is the company4s cost of common stock, rs% a. 2.0' (. 2.2' c. 11.0' d. 12.2' e. 12.1' Cost of common stock Answer: b Diff: M 2 . ;artin Corporation's common stock is currently sellin" for $&0 per share. -he current dividend is $2.00 per share. 7f dividends are e0pected to "ro! at # percent per year, then !hat is the firm's cost of common stock% a. (. c. d. e. WACC , . 10.0' 10.2' 10.#' 10.,' 11.0'

Answer: b Diff: M / company has determined that its optimal capital structure consists of 10 percent de(t and #0 percent e5uity. .iven the follo!in" information, calculate the firm's !ei"hted avera"e cost of capital. rd > #' -a0 rate > 10' ?0 > $2& .ro!th > 0' D0 > $2.00 a. (. c. d. e. #.0' #.2' 2.0' 2.2' ,.0'

Chapter 9 - Page 3

WACC + .

Answer: c Diff: M @ohnson 7ndustries finances its pro8ects !ith 10 percent de(t, 10 percent preferred stock, and &0 percent common stock. -he company can issue (onds at a yield to maturity of ,.1 percent. -he cost of preferred stock is + percent. -he company's common stock currently sells for $)0 a share. -he company's dividend is currently $2.00 a share (D0 > $2.00 , and is e0pected to "ro! at a constant rate of # percent per year. /ssume that the flotation cost on de(t and preferred stock is Aero, and no ne! stock !ill (e issued. -he company4s ta0 rate is )0 percent.

$hat is the company4s !ei"hted avera"e cost of capital ($/CC % a. ,.))' (. +.)2' c. +.2+' d. +.++' e. 1).1&' WACC 10 . Answer: e Diff: M Do(son Dairies has a capital structure !hich consists of #0 percent lon"6term de(t and 10 percent common stock. -he company4s C=B has o(tained the follo!in" information3 -he (efore6ta0 yield to maturity on the company4s (onds is , percent. -he company4s common stock is e0pected to pay a $).00 dividend at year end (D1 > $).00 , and the dividend is e0pected to "ro! at a constant rate of 2 percent a year. -he common stock currently sells for $#0 a share. /ssume the firm !ill (e a(le to use retained earnin"s to fund the e5uity portion of its capital (ud"et. -he company4s ta0 rate is 10 percent.

$hat is the company4s !ei"hted avera"e cost of capital ($/CC % a. 12.00' (. ,.0)' c. +.)1' d. ,.00' e. 2.#,' Multiple part: (The following information applies to the next six problems.) <ollins Corporation is estimatin" its $/CC. 7ts tar"et capital structure is 20 percent de(t, 20 percent preferred stock, and #0 percent common e5uity. 7ts (onds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. -he firm could sell, at par, $100 preferred stock !hich pays a 12 percent annual dividend, (ut flotation costs of & Chapter 9 - Page 4

percent !ould (e incurred. <ollins' (eta is 1.2, the risk6free rate is 10 percent, and the market risk premium is & percent. <ollins is a constant6 "ro!th firm !hich 8ust paid a dividend of $2.00, sells for $22.00 per share, and has a "ro!th rate of , percent. -he firm's policy is to use a risk premium of 1 percenta"e points !hen usin" the (ond6yield6plus6risk6premium method to find rs. -he firm's mar"inal ta0 rate is 10 percent. Cost of debt 11 . $hat is <ollins' component cost of de(t% a. 10.0' (. +.1' c. ,.#' d. ,.0' e. 2.2' Cost of preferred stock 12 . $hat is <ollins' cost of preferred stock% a. (. c. d. e. 10.0' 11.0' 12.0' 12.#' 1).2' Answer: c Diff: E usin" the C/?; approach% Answer: d Diff: E Answer: e Diff: M

Cost of common stock: CAPM 1) . $hat is <ollins' cost of common stock (rs a. (. c. d. e. 1).#' 11.1' 1#.0' 1#.#' 1#.+'

Cost of common stock: DCF 11 . $hat is the firm's cost of common stock (rs a. (. c. d. e. 1).#' 11.1' 1#.0' 1#.#' 1#.+'

Answer: c Diff: E usin" the DC= approach%

Cost of common stock: Risk premium Answer: c Diff: E 1& . $hat is <ollins' cost of common stock usin" the (ond6yield6plus6risk6 premium approach% a. (. c. d. e. WACC 1).#' 11.1' 1#.0' 1#.#' 1#.+' Answer: a Diff: E

Chapter 9 - Page 5

1#

$hat is <ollins' $/CC% a. (. c. d. e. 1).#' 11.1' 1#.0' 1#.#' 1#.+'

(The following information applies to the next three problems.) @. <oss and :ons 7nc. has a tar"et capital structure that calls for 10 percent de(t, 10 percent preferred stock, and &0 percent common e5uity. -he firm's current after6ta0 cost of de(t is # percent, and it can sell as much de(t as it !ishes at this rate. -he firm's preferred stock currently sells for $+0 per share and pays a dividend of $10 per share9 ho!ever, the firm !ill net only $,0 per share from the sale of ne! preferred stock. <oss's common stock currently sells for $10 per share. -he firm recently paid a dividend of $2 per share on its common stock, and investors e0pect the dividend to "ro! indefinitely at a constant rate of 10 percent per year. Cost of common stock 12 . $hat is the firm's cost of common stock, rs% a. (. c. d. e. 10.0' 12.&' 1&.&' 1#.&' 1,.0' Diff: E Answer: c Diff: E

Cost of preferred stock Answer: b 1, . $hat is the firm's cost of ne!ly issued preferred stock, rps% a. (. c. d. e. WACC 1+ . 10.0' 12.&' 1&.&' 1#.&' 1,.0'

Answer: d $hat is the firm's !ei"hted avera"e cost of capital ($/CC % a. (. c. d. e. +.&' 10.)' 10.,' 11.1' 11.+'

Diff: E

Cost of equit Answer: a Diff: M 20 . /llison Cn"ines Corporation has esta(lished a tar"et capital structure of 10 percent de(t and #0 percent common e5uity. -he firm e0pects to earn $#00 in after6ta0 income durin" the comin" year, and it !ill retain 10 percent of those earnin"s. -he current market price of the firm's stock is ?0 > $2,9 its last dividend !as D0 > $2.20, and its e0pected "ro!th rate is # percent. /llison can issue ne! common stock Chapter 9 - Page 6

at a 1& percent flotation cost. $hat !ill /llison's mar"inal cost of equity capital (not the $/CC (e if it must fund a capital (ud"et re5uirin" $#00 in total ne! capital% a. 1&.,' (. 1).+' c. 2.+' d. 11.)' e. +.2' WACC 21 . Answer: b Diff: M Dilliard Corp. !ants to calculate its !ei"hted avera"e cost of capital ($/CC . -he company4s C=B has collected the follo!in" information3 -he company4s lon"6term (onds currently offer a yield to maturity of , percent. -he company4s stock price is $)2 per share (?0 > $)2 . -he company recently paid a dividend of $2 per share (D0 > $2.00 . -he dividend is e0pected to "ro! at a constant rate of # percent a year (" > #' . -he company pays a 10 percent flotation cost !henever it issues ne! common stock (= > 10' . -he company4s tar"et capital structure is 2& percent e5uity and 2& percent de(t. -he company4s ta0 rate is 10 percent. -he company anticipates issuin" ne! common stock durin" the upcomin" year.

$hat is the company4s $/CC% a. (. c. d. e. 10.#2' 11.22' 11.12' 12.02' 12.&#'

Chapter 9 - Page 7

Fi!a!cial Calculat"' Secti"!

Multi&le C$"ice: P'"(le s Medium:
(The following information applies to the next four problems. calculator required.) Financial

*ou are employed (y C.-, a =ortune &00 firm that is a ma8or producer of chemicals and plastic "oods3 plastic "rocery (a"s, styrofoam cups, and fertiliAers. *ou are on the corporate staff as an assistant to the Eice6 ?resident of =inance. -his is a position !ith hi"h visi(ility and the opportunity for rapid advancement, providin" you make the ri"ht decisions. *our (oss has asked you to estimate the !ei"hted avera"e cost of capital for the company. =ollo!in" are (alance sheets and some information a(out C.-. Assets Current assets Fet plant, property, and e5uipment !otal Assets (iabilities and Equit /ccounts paya(le /ccruals Current lia(ilities Gon" term de(t (10,000 (onds, $1,000 face value -otal lia(ilities Common :tock 10,000,000 shares <etained Carnin"s -otal shareholders e5uity !otal liabilities and shareholders equit $),,000,000 $101,000,000 "#$%&'''&'''

$10,000,000 $+,000,000 $1+,000,000 $10,000,000 $&+,000,000 $)0,000,000 $&0,000,000 $,0,000,000 "#$%&'''&'''

*ou check The Wall treet !ournal and see that C.- stock is currently sellin" for $2.&0 per share and that C.- (onds are sellin" for $,,+.&0 per (ond. -hese (onds have a 2.2& percent annual coupon rate, !ith semi6annual payments. -he (onds mature in t!enty years. -he (eta for your company is appro0imately e5ual to 1.1. -he yield on a #6month -reasury (ill is ).& percent and the yield on a 206year -reasury (ond is &.& percent. -he e0pected return on the stock market is 11.& percent, (ut the stock market has had an avera"e annual return of 11.& percent durin" the past five years. C.is in the 10 percent ta0 (racket.

Chapter 9 - Page 8

CAPM cost of equit Answer: b Diff: M 22 . Hsin" the C/?; approach, !hat is the (est estimate of the cost of e5uity for C.-% a. (. c. d. e. 10.10' 12.10' 12.)0' 1&.10' 1&.#0' Diff: M

After)ta* cost of debt Answer: d 2) . $hat is (est estimate for the after6ta0 cost of de(t for C.-% a. (. c. d. e. 2.&2' 1.20' 1.)&' &.01' &.)2'

Wei+hts for WACC Answer: d Diff: M 21 . $hich of the follo!in" is the (est estimate for the !ei"hts to (e used !hen calculatin" the $/CCC% a. (. c. d. e. WACC 2& . !e !e !e !e !e > > > > > &2.#' #&.2' ##.2' #2.,' 22.1' and and and and and !d !d !d !d !d > > > > > 12.1' )1.,' )).)' )2.2' 22.#' Answer: e $hat is the (est estimate of the $/CC for C.-% a. (. c. d. e. ,.#&' ,.+2' +.1,' +.2&' +.,)' Diff: M

Component cost of debt Answer: b Diff: M 2# . Damilton Company's , percent coupon rate, 5uarterly payment, $1,000 par value (ond, !hich matures in 20 years, currently sells at a price of $#,#.,#. -he company's ta0 rate is 10 percent. Based on the nominal interest rate, not the C/<, !hat is the firm's component cost of de(t for purposes of calculatin" the $/CC% a. ).0&' (. 2.)2' c. 2.)#' d. 12.20' e. 12.2#'

Chapter 9 - Page 9

WACC 22 .

Answer: a Diff: M / stock analyst has o(tained the follo!in" information a(out @6;art, a lar"e retail chain3 (1 -he company has noncalla(le (onds !ith 20 years maturity remainin" and a maturity value of $1,000. -he (onds have a 12 percent annual coupon and currently sell at a price of $1,22).,&#1. (2 Bver the past four years, the returns on the market and on @6;art !ere as follo!s3 *ear 2001 2002 200) 2001 () ;arket 12.0' 12.2 6)., 20.0 @6;art 11.&' 22.2 62.& 21.0

-he current risk6free rate is #.)& percent, and the e0pected return on the market is 11.)& percent. -he company's ta0 rate is )& percent.

-he company anticipates that its proposed investment pro8ects !ill (e financed !ith 20 percent de(t and )0 percent e5uity. $hat is the company's estimated !ei"hted avera"e cost of capital ($/CC % a. ,.01' (. +.00' c. 10.2&' d. 12.))' e. 1).11'

Chapter 9 - Page 10

CHAPTER 9 A)S*ERS A)D SOL+TIO)S

Chapter 9 - Page 11

1,

Cost of common stock -he cost of common stock is3

Answer: d

Diff: E

rs > $1(1.0# I$20 J 0.0# > 0.0&) J 0.0# > 0.11) > 11.)'. 2, Cost of common stock rs > ), Answer: b Diff: E

$2.00(1.0& $&0

J &' > +.2'. Answer: e Diff: E

Cost of common stock rs >

$0.+0(1.0& $,.&+

J 0.0& > 0.1#00 > 1#.00'.

1,

WACC with Flotation Costs

Answer: a

Diff: E

$/CC > !drd(1 6 - J !cere. rd is "iven > +'. =ind re3 re > D1IK?0(1 6 = L J " > $0.,IK$2&(1 6 0.1 L J 0.0+ > 0.12&&&#. Fo! you can calculate $/CC3 $/CC > (0.) (0.0+ (0.# J (0.2 (0.12&&&# > 10.11'. &, WACC Answer: d Diff: M

$ei"hts should (e (ased on the tar"et capital structure3 ! d > 10' and !e > #0'. -he cost of de(t should (e (ased on the yield of 11.11'. $/CC > 0.#0 (12' J 0.1 (16.1 (11.11' > +.,2'. #, Cost of common stock -he rs > > > Answer: d Diff: M

2 ,

cost of common e5uity as calculated from the C/?; is r<= J (r; 6 r<= ( &' J (#' 1.2 12.2'. Answer: b Diff: M

Cost of common stock rs >

$2.00(1.0# $&0

J 0.0#' > 10.21' 10.2'. Answer: b Diff: M

,,

WACC =ind the cost of common stock3 rs > D1I?0 J " > $2(1.0 I$2& J 0'9 rs > 0.0, > ,'.

+ ,

=inally, calculate $/CC, usin" rs > 0.0,, and rd > 0.0#, so $/CC > (DI/ (1 6 -a0 rate rd J (CI/ rs > 0.1(1 6 0.1 (0.0# J 0.#(0.0, > 0.0#21 #.2'. WACC -he cost of common stock is3 Answer: c Diff: M

rs > D1I?0 J " > $2.12I$)0 J 0.0# > 1).02'.

-he cost to the company of the (onds is the *-; multiplied (y 1 minus the ta0 rate3 rd > *-;(1 6 - > ,.1'(0.2 > &.,,'. -he cost of the preferred is "iven as +'. -he !ei"hted avera"e cost of capital is then $/CC > !d(rd J !ps(rps J !ce(rs $/CC > 0.1(&.,,' J 0.1(+' J 0.&(1).02' > +.2+'. 10, WACC Answer: e Diff: M

-he firm !ill not (e issuin" ne! e5uity (ecause there are ade5uate retained earnin"s availa(le to fund availa(le pro8ects. -herefore, $/CC should (e calculated usin" rs. rs > D1I?0 J " > $).00I$#0.00 J 0.02 > 0.12 > 12'. $/CC > !drd(1 6 - J !cers > (0.# (0.0, (1 6 0.1 > 0.02#, > 2.#,'. Cost of debt -ime line3 0 rd / 2 = ? 1 J (0.1 (0.12 Answer: e Diff: M

11,

10 #6month MNNNNNNNNNNNONNNNNONNNNNNNNONNNNNNNNNONNNPPPNNNNNNNQ ?eriods ?;- > #0 EB > 1,000 #0 #0 #0 #0 =E > 1,000

:ince the (ond sells at par of $1,000, its *-; and coupon rate (12 percent are e5ual. -hus, the before"tax cost of de(t to <ollins is 12 percent. -he after"tax cost of de(t e5uals3 rd,/fter6ta0 > 12.0'(1 6 0.10 > 2.2'. =inancial calculator solution3 7nputs3 F > 109 ?E > 61,0009 ?;- > #09 =E > 1,0009 Butput3 7 > #.0' > rdI2. rd > #.0' 2 > 12'. rd(1 6 - > 12.0'(0.# > 2.2'. 12, 1) , Cost of preferred stock Cost of preferred stock3 Cost of common stock: CAPM Cost of common stock (C/?; approach 3 rs > 10' J (&' 1.2 > 1#.0'. 11, Cost of common stock: DCF Cost of common stock (DC= approach 3 rs > 1& Answer: c Diff: E rps > $12I$100(0.+& Answer: d > 12.#'. Answer: c Diff: E Diff: E

$2.00(1.0, $22

J ,' > 1#.0'.

Cost of common stock: Risk premium

Answer: c

Diff: E

Cost of common stock (Bond yield6plus6risk6premium approach 3 rs > 12.0' J 1.0' > 1#.0'. 1# , WACC $/CC > !drd(1 6 - J !psrps J !cers > 0.2(12.0' (0.# J 0.2(12.#' 12 , Cost of common stock rs > 1,, Answer: c Diff: E J 0.#(1#.0' Answer: a Diff: E

> 1).&#' 1).#'.

$2.00(1.10 $10.00

J 0.10 > 1&.&'. Answer: b Diff: E

Cost of preferred stock rps >

$10 > 12.&'. $,0

Answer: d Answer: a Diff: E Diff: M

1+, 20 ,

WACC Cost of equit

#alculate the retained earnings brea$ point: .iven3 Fet income > $#009 De(t > 0.19 C5uity > 0.#9 Dividend payout > 0.#. Break point<C > $#00(1 6 0.# I0.# > $100. /llison !ill need ne! e5uity capital9 capital (ud"et e0ceeds Break point<C. %se the di&idend growth model to calculate re: re >

D0 ( 1 + ") $2.20( 1.0#) J " > J 0.0# $2,( 1 0.1&) ?0 ( 1 =)

> 0.0+2+ J 0.0# > 0.1&2+ 1&.,'. 21, WACC Answer: b Diff: M

-he correct ans!er is (, 11.22'. /s there are no retained earnin"s, the e5uity portion of the capital (ud"et must (e funded usin" ne! common e5uity. $/CC > $d(rd (1 6 - J !ce(re > 0.2&(0.0, (1 6 0.1 J 0.2&K($2.00 0 1.0# I($)2(1 6 0.1 J 0.0#L > 0.2&(0.01,0 J 0.2&(0.1))# > 0.1122 > 11.22'. 22, CAPM Cost of Equit rs > &.&' J 1.1(11.&'6&.&' 2), After)ta* cost of debt F>10 7>% ?E>6,,+.&0 ?;->)#.2& =E>1,000 > 12.10'. Answer: d Diff: M Answer: b Diff: M

7>1.2 rd > 1.2(2 > ,.1'. > &.01'. Answer: d Diff: M

rd after6ta0 > ,.1'(160.10 21, Wei+hts for WACC

Hse market values for estimatin" the !ei"hts, since tar"et values are not availa(le. ;arket value of e5uity > Ee > $2.&0(10 million > $2& million. ;arket value of de(t > Ed > $,,+.&0(10,000 > $)&.&, million. $e > $2&I($2&J$)&.&, > 0.#2, > #2.,'. $d > $)&.&,I($2&J$)&.&, > 0.)22 > )2.2'. 2&, WACC $/CC > 0.#2, (12.10' 2# $/CC > 0.1(#' > 11.1'. J 0.)22 (&.01' > +.,)'. > !drd(1 6 J !psrps J !cers Answer: e Diff: M

J 0.1(12.&'

J 0.&(1&.&'

Component cost of debt -ime line3 0 rd > %

Answer: b

Diff: M

2 20

) 20

1 20

,0 20 =E > 1,000

?;- > 20 EB > #,#.,#

MNNNNNNNNONNNNNNONNNNNNNONNNNNNNONNNPPPNNNNNQRuarters

22 ,

=inancial calculator solution3 #alculate the nominal 'TM of bond: 7nputs3 F > ,09 ?E > 6#,#.,#9 ?;- > 209 =E > 1,000. Butput3 7 > ).0&' periodic rate. Fominal annual rate > ).0&' 1 > 12.20'. #alculate rd after"tax: rd,/- > 12.20'(1 6 - > 12.20'(1 6 0.1 WACC

> 2.)2'. Diff: M

Answer: a

$/CC > K(0.2 (rd (1 6 - L J K(0.) (rs L. a. Hse (ond information to solve for rd3 F > 209 ?E > 61,22).,&#19 ?;- > 1209 =E > 1,000. :olve for rd > +'. (. -o solve for rs, !e can use the :;G e5uation, (ut !e need to find (eta. Hsin" ;arket and @6;art return information and a calculator's re"ression feature !e find ( > 1.)&,&. :o rs > 0.0#)& J (0.11)& 6 0.0#)& (1.)&,& > 0.1)11 > 1).11'. c. ?lu" these values into the $/CC e5uation and solve3 $/CC > K(0.2 (0.0+ (1 6 0.)& L J K(0.) (0.1)11 L > 0.0,01 > ,.01'.