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Cost of Capital

Cost of Capital

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CHAPTER 9 THE COST OF CAPITAL

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Problems Easy:
Cost of common stock Answer: d Diff: E 1 . B & B Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its growth rate is a constant 6 percent. What is its cost of common stock, rs? a. 5.0% b. 5.3% c. 11.0% d. 11.3% e. 11.6% Cost of common stock Answer: b Diff: E 2 . Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate is a constant 5 percent. What is the cost of common stock, rs? a. 9.0% b. 9.2% c. 9.6% d. 9.8% e. 10.0% Cost of common stock Answer: e Diff: E 3 . The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. What is Global's cost of common stock? a. b. c. d. e. 12.22% 17.22% 10.33% 9.66% 16.00%

Chapter 9 - Page 1

e. 10. Answer: d Diff: M A company’s balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The tax rate is 40%.87% e.29% Medium: WACC 5 . • The company’s year-end dividend is forecasted to be $0. • The company’s tax rate is 40 percent. The yield to maturity on this debt is 11. An analyst has Christopher Co. • The yield to maturity on the company’s bonds is 9 percent. is 12 percent.33% c. 10. • The company anticipates that it will need to raise new common stock this year.41% 12.WACC with Flotation Costs 4 .Page 2 . 8. The current stock price is $7. Assume the company accounts for flotation costs by adjusting the cost of capital.55% 9. 9. • The company expects that its dividend will grow at a constant rate of 9 percent a year. 9. b. • The company’s stock price is $25.55% b. rS. 30 percent debt. the total of common stock and retained earnings is $30 million. c. Given this information. What weighted average cost of capital should you use to evaluate potential projects? a.67% Chapter 9 . The company has a target capital structure of 40 percent debt and 60 percent equity. The balance sheets also show that that the company has 10 million shares of stock.56% 10.78% 13. The current return required by stockholders. 9. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued.: collected the following Answer: a Diff: E information regarding • The company’s capital structure is 70 percent equity. d.11 percent. calculate the company’s WACC.5 per share. a. and the debt has a total current market value of $25 million.80 a share.36% d.

10. e.2% 7.20. 7. d. 12.2% 8.0% Chapter 9 . The common stock of Anthony Steel has a beta of 1. e.Cost of common stock Answer: d Diff: M 6 .0% Answer: b Diff: M A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. c. WACC 8 . rd = 6% Tax rate = 40% P0 = $25 Growth = 0% D0 = $2.rRF) is 6 percent.0% b. 11.0% 7. Martin Corporation's common stock is currently selling for $50 per share.8% 11.0% d.2% e.6% 10.2% c. d. What is the company’s cost of common stock. then what is the firm's cost of common stock? a.4% Cost of common stock Answer: b Diff: M 7 . Given the following information. The risk-free rate is 5 percent and the market risk premium (rM .0% 10.00 per share. rs? a.00 a. b. calculate the firm's weighted average cost of capital. c. 6. The current dividend is $2.2% 10. 12. If dividends are expected to grow at 6 percent per year. 7. b.0% 6.Page 3 .

and 60 percent common equity. The company’s common stock is expected to pay a $3. a current maturity of 20 years. 8. 20 percent preferred stock.00).15% WACC 10 . • The company’s tax rate is 30 percent.68% Multiple part: (The following information applies to the next six problems. the risk-free rate is 10 Chapter 9 . What is the company’s weighted average cost of capital (WACC)? a. The company's common stock currently sells for $30 a share. 9. Answer: e Diff: M Dobson Dairies has a capital structure which consists of 60 percent long-term debt and 40 percent common stock. Its bonds have a 12 percent coupon.00). 9. The cost of preferred stock is 9 percent. paid semiannually. 8. and is expected to grow at a constant rate of 6 percent per year.32% c.WACC 9 .00 dividend at year end (D1 = $3. Answer: c Diff: M Johnson Industries finances its projects with 40 percent debt.) Rollins Corporation is estimating its WACC. • • • The company can issue bonds at a yield to maturity of 8.4 percent.000. 12. $100 preferred stock which pays a 12 percent annual dividend.79% d. and sell for $1.34% d. at par. The company’s CFO has obtained the following information: The before-tax yield to maturity on the company’s bonds is 8 percent. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. and the dividend is expected to grow at a constant rate of 7 percent a year. • The company’s tax rate is 40 percent. and 50 percent common stock. Rollins' beta is 1. 9.33% b. but flotation costs of 5 percent would be incurred. 10 percent preferred stock.00 a share (D0 = $2.00% e. 8. and no new stock will be issued.00% b. What is the company’s weighted average cost of capital (WACC)? a. 13. The firm could sell. • Assume that the flotation cost on debt and preferred stock is zero. Its target capital structure is 20 percent debt. 9.2. The common stock currently sells for $60 a share. • The company's dividend is currently $2.Page 4 • • • .03% c.99% e. 7.

13. e. e. sells for $27.Page 5 Diff: E . 13.1% 16. c.2% Cost of preferred stock 12 .6% 14.6% 14. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. What is Rollins' cost of preferred stock? a. 10.0% b. 9.9% Cost of common stock: DCF Answer: c Diff: E 14 . 7.6% 16.1% c. e.6% 16.1% 16.6% 16. c. d.0% 16. What is Rollins' component cost of debt? a. d.0% 12. 10. What is Rollins' cost of common stock using the bond-yield-plus-riskpremium approach? a. 8. e. d. and has a growth rate of 8 percent. d. b. c. The firm's marginal tax rate is 40 percent. 8.00.0% e.0% 16.9% Cost of common stock: Risk premium Answer: c Diff: E 15 .6% d.0% 16. b.00 per share.2% Answer: d Diff: E Answer: e Diff: M Cost of common stock: CAPM Answer: c Diff: E 13 . Rollins is a constantgrowth firm which just paid a dividend of $2. and the market risk premium is 5 percent.1% 16.6% 13.percent. Cost of debt 11 .0% 11. b. b. c. WACC 16 .9% Answer: a What is Rollins' WACC? Chapter 9 . What is Rollins' cost of common stock (rs) using the CAPM approach? a.6% 14. 13. What is the firm's cost of common stock (rs) using the DCF approach? a.0% 12.

and its expected growth rate is 6 percent. The firm expects to earn $600 in after-tax income during the coming year. 10.5% 18.5% 10. b. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.a.0% 16. rps? a.0% 12.) J. 10. and 50 percent common equity. its last dividend was D0 = $2. What is the firm's cost of newly issued preferred stock. rs? a.6% 16.20. 9.9% Diff: E Cost of equity Answer: a Diff: M 20 .0% Answer: d What is the firm's weighted average cost of capital (WACC)? a. e. The firm recently paid a dividend of $2 per share on its common stock. The current market price of the firm's stock is P0 = $28. b. Ross's common stock currently sells for $40 per share. e. and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. WACC 19 . and it will retain 40 percent of those earnings. The firm's current after-tax cost of debt is 6 percent.9% (The following information applies to the next three problems. What will Allison's marginal cost of Chapter 9 . e.3% 10.6% 14. c. b. Cost of common stock 17 . 13. b.4% 11. has a target capital structure that calls for 40 percent debt.0% Diff: E Answer: c Diff: E Cost of preferred stock Answer: b 18 .5% 16.5% 15.8% 11.5% 15. c. c. e. d. however. d. 10 percent preferred stock. Ross and Sons Inc. c. and it can sell as much debt as it wishes at this rate.5% 16. Allison can issue new common stock at a 15 percent flotation cost. the firm will net only $80 per share from the sale of new preferred stock. d. d.5% 18.Page 6 .0% 12.1% 16. What is the firm's cost of common stock. The firm's preferred stock currently sells for $90 per share and pays a dividend of $10 per share.

7% WACC 21 .47% 12. • The company pays a 10 percent flotation cost whenever it issues new common stock (F = 10%). • The company anticipates issuing new common stock during the upcoming year. • The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%). 15. b.00). 10. 14.equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital? a. The company’s CFO has collected the following information: • The company’s long-term bonds currently offer a yield to maturity of 8 percent. 9.22% 11.9% c.9% d. Answer: b Diff: M Hilliard Corp.Page 7 . 13. • The company’s target capital structure is 75 percent equity and 25 percent debt. c.67% 11. wants to calculate its weighted average cost of capital (WACC).02% 12. The company recently paid a dividend of $2 per share (D0 = $2.3% e. 7.8% b. What is the company’s WACC? a. • The company’s tax rate is 40 percent. d. e. • • The company’s stock price is $32 per share (P0 = $32).56% Chapter 9 .

Financial Calculator Section Multiple Choice: Problems Medium: (The following information applies to the next four problems. CGT is in the 40 percent tax bracket. The bonds mature in twenty years.5 percent.000.000. with semi-annual payments.25 percent annual coupon rate.) Financial You are employed by CGT.000.Page 8 .000 face value) Total liabilities Common Stock 10. and equipment Total Assets Liabilities and Equity Accounts payable Accruals Current liabilities Long term debt (40. $1. a Fortune 500 firm that is a major producer of chemicals and plastic goods: plastic grocery bags. Following are balance sheets and some information about CGT.1. Your boss has asked you to estimate the weighted average cost of capital for the company. The beta for your company is approximately equal to 1.000 $59.000.000 $139. The yield on a 6-month Treasury bill is 3. These bonds have a 7.000.000 $50.000 $40.000.5 percent.5 percent during the past five years.000 $30.000.000.000 $9.000. property.000.000 shares) Retained Earnings Total shareholders equity Total liabilities and shareholders equity $38. Assets Current assets Net plant.000 $101. providing you make the right decisions. This is a position with high visibility and the opportunity for rapid advancement.000.000 $139. Chapter 9 . and fertilizers.5 percent and the yield on a 20-year Treasury bond is 5.000 $80.000 bonds. but the stock market has had an average annual return of 14.50 per bond. calculator required.000 You check The Wall Street Journal and see that CGT stock is currently selling for $7.000 $19.000.50 per share and that CGT bonds are selling for $889. The expected return on the stock market is 11. You are on the corporate staff as an assistant to the VicePresident of Finance.000. styrofoam cups.000 $10.

Based on the nominal interest rate.000 par value bond.6% Answer: e What is the best estimate of the WACC for CGT? a.26% Chapter 9 . e. d.30% 15. what is the best estimate of the cost of equity for CGT? a.10% 12.18% 9.20% e. Using the CAPM approach.10% 12. 12. e. b. d.Page 9 . What is best estimate for the after-tax cost of debt for CGT? a.36% d.7% 67.52% 4.6% 65. 7.83% Diff: M Component cost of debt Answer: b Diff: M 26 .2% 66. 7.32% c.92% 9. not the EAR. 3. which matures in 20 years. e.75% 9. b. WACC 25 . 8.05% b. e.65% 8.20% 4. b. c.37% Weights for WACC Answer: d Diff: M 24 . c. what is the firm's component cost of debt for purposes of calculating the WACC? a. currently sells at a price of $686.60% Diff: M After-tax cost of debt Answer: d 23 . b. d.8% 33.04% 5. Which of the following is the best estimate for the weights to be used when calculating the WACCC? a. 10. The company's tax rate is 40 percent.2% 27. c.8% 72.35% 5. we we we we we = = = = = 57.4% and and and and and wd wd wd wd wd = = = = = 42. c. d.86.3% 32.40% 15. 12. Hamilton Company's 8 percent coupon rate. quarterly payment. 2.CAPM cost of equity Answer: b Diff: M 22 .4% 34. $1.

Answer: a Diff: M A stock analyst has obtained the following information about J-Mart.14% Chapter 9 .0% 17.0 J-Mart 14. The company's tax rate is 35 percent. 13.2 -7.33% e. 8. 10. the returns on the market and on J-Mart were as follows: Year 2001 2002 2003 2004 Market 12.35 percent.0 (3) The current risk-free rate is 6.5% 22.35 percent. 12.5 24.04% b.000. (2) Over the past four years.25% d. The company anticipates that its proposed investment projects will be financed with 70 percent debt and 30 percent equity.8 20. The bonds have a 12 percent annual coupon and currently sell at a price of $1.00% c. and the expected return on the market is 11. a large retail chain: (1) The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1. What is the company's estimated weighted average cost of capital (WACC)? a.8564. 9.Page 10 .2 -3.WACC 27 .273.

Page 11 .CHAPTER 9 ANSWERS AND SOLUTIONS Chapter 9 .

0624 ≈ 6.1)] + 0.4) (11.60 (12%) + 0.06 = 0.T) + wcere. using rs = 0.Tax rate)rd + (E/A)rs = 0. calculate WACC.0)/$25 + 0%.05 = 0. WACC = 0.11%) = 9.06% = 10. Find re: re = D1/[P0(1 .09)(0.12/$30 + 0.41%.rRF)b 5% + (6%)1. Answer: b Diff: M Cost of common stock rs = $2. rd is given = 9%.08 = 8%. so WACC = (D/A)(1 .07%. Now you can calculate WACC: WACC = (0. Cost of common stock rs = 3.2%.125556.1.00(1.3%. and rd = 0.59 4. The cost of debt should be based on the yield of 11.2 12.06) + 0.0.7)(0.2%.2%.125556) = 10.90(1. 9 .4 (1-.08.06)/$20 + 0. $50 Answer: e Diff: E Cost of common stock rs = $0.0. $5 0 Answer: b Diff: M 8. Finally.06 = 13.2%.3)(0.05) + 0. $8.09 = 0.00(1. 6. cost of common equity as calculated from the CAPM is rRF + (rM .24% ≈ 10. Cost of common stock The cost of common stock is: Answer: d Diff: E rs = $1(1.00%. .06 = 0.4)(0.1600 = 16.05 ) + 5% = 9. WACC Find the cost of common stock: rs = D1/P0 + g = $2(1.08) = 0. WACC Answer: d Diff: M Weights should be based on the target capital structure: wd = 40% and we = 60%.6(0.11%.06. 5. WACC with Flotation Costs Answer: a Diff: E WACC = wdrd(1 . Answer: b Diff: E $2.87%.6) + (0. Cost of common stock The rs = = = Answer: d Diff: M 7 .4(1 . 2.0 6) + 0.113 = 11. rs = 0.053 + 0.F)] + g = $0.8/[$25(1 . WACC The cost of common stock is: Answer: c Diff: M rs = D1/P0 + g = $2.

$27 .0% × 2 = 12%.2 = 16.000 60 60 60 60 FV = 1. Thus.07%) = 9.08) + 8% = 16.0%(0.After-tax = 12. Therefore. The cost of the preferred is given as 9%. 12. PV = -1.95) = 12.2%.68%. WACC should be calculated using rs.00(1.2%. FV = 1. Answer: e Diff: M 40 6-month ├───────────┼─────┼────────┼─────────┼───∙∙∙───────┤ Periods PMT = 60 VB = 1.4) + (0.0%(1 .07 = 0.T) = 8. rd(1 .000. Output: I = 6.40) = 7. Answer: c Diff: E Diff: E $2.000.88%. WACC = wdrd(1 .1(9%) + 0. The weighted average cost of capital is then WACC = wd(rd) + wps(rps) + wce(rs) WACC = 0.79%. 14.08)(1 .4)(0.6)(0.0.00 + 0.000 2 3 4 Since the bond sells at par of $1. The after-tax cost of debt equals: rd. 10. Cost of common stock: DCF Cost of common stock (DCF approach): rs = 15 Answer: c Diff: E Answer: d rps = $12/$100(0. rs = D1/P0 + g = $3.0%. rd = 6.7) = 5.6) = 7.00/$60.T) + wcers = (0. Cost of debt Time line: 0 rd / 2 = ? 1 11.12 = 12%. WACC Answer: e Diff: M The firm will not be issuing new equity because there are adequate retained earnings available to fund available projects.88%) + 0.5(13.0%.000.12) = 0. Cost of preferred stock Cost of preferred stock: Cost of common stock: CAPM Cost of common stock (CAPM approach): rs = 10% + (5%)1. PMT = 60. the before-tax cost of debt to Rollins is 12 percent. Financial calculator solution: Inputs: N = 40.6%.0768 = 7.4(5. 13 .The cost to the company of the bonds is the YTM multiplied by 1 minus the tax rate: rd = YTM(1 .0. its YTM and coupon rate (12 percent) are equal.4%(0.T) = 12.0% = rd/2.

5%) = 12.25(0.0% + 4. WACC Answer: b Diff: M The correct answer is b.06] = 0.15) P0 ( 1 − F ) = 0. CAPM Cost of Equity rs = 5.6.6.10 = 15.6)/0. Debt = 0. the equity portion of the capital budget must be funded using new common equity. capital budget exceeds Break pointRE. WACC = Wd(rd)(1 .6) + 0.4) + 0.000 Answer: d Diff: M Answer: b Diff: M . $40.6(16. 17 .00 x 1. Equity = 0.0.22%. Break pointRE = $600(1 .1579 ≈ 15.2(12.22%.25(0.5%-5. Dividend payout = 0.1)) + 0.1(11.00 Answer: b Diff: E Cost of preferred stock rps = $10 $80 = 12.56% ≈ 13.20( 1. After-tax cost of debt N=40 I=? PV=-889.75(0.1336) = 0.75[($2.00(1.0%. Use the dividend growth model to calculate re: re = D0 ( 1 + g) $2.10) + 0. 16 .T) + wce(re) = 0.08)(1 .5% + 1. Allison will need new equity capital.8%.0.6 = $400.06) + g = + 0. 11.50 PMT=36.6%) + 0.T) + wpsrps + wcers = 0.06 = 0. Cost of common stock: Risk premium Answer: c Diff: E Cost of common stock (Bond yield-plus-risk-premium approach): rs = 12.4.5%.0979 + 0.25 FV=1. 23.0480) + 0. WACC Cost of equity Calculate the retained earnings break point: Given: Net income = $600.0%) = 13. Cost of common stock rs = 18.06)/($32(1 . 21.1122 = 11.5%.. Answer: c Diff: E $2.2(12. 22.0% = 16.10%.06 $28( 1 − 0.6%.0%)(0. As there are no retained earnings. WACC Answer: a Diff: E WACC = wdrd(1 . 20 .0. Answer: d Answer: a Diff: E Diff: M 19.

Market value of equity = Ve = $7.0635)(1.4%(1-0. 24.000. PV = -686.7)(rd)(1 .58) = 0. FV = 1.1314)] = 0.58/($75+$35.50(10 million) = $75 million.AT = 12.86.32%. .58 million. Component cost of debt Time line: 0 rd = ? = wdrd(1 .4) = 7.20%(1 .T)] + [(0.3585) = 0. Nominal annual rate = 3.0.4%. since target values are not available. Financial calculator solution: Calculate the nominal YTM of bond: Inputs: N = 80. Using Market and J-Mart return information and a calculator's regression feature we find b = 1.273.1314 = 13. Answer: b Diff: M 1 2 20 3 20 4 20 80 20 FV = 1.40) = 5. Weights for WACC Answer: d Diff: M Use market values for estimating the weights. Calculate rd after-tax: rd. PMT = 120.10%) + 0. but we need to find beta. c.678 = 67.T) = 12.0.5%) = 11.05% × 4 = 12. Use bond information to solve for rd: N = 20.8%. We = $75/($75+$35.678 (12.14%.8564.T) + wpsrps + wcers Answer: e Diff: M .3)(rs)].0804 = 8.35)] + [(0.000. rd after-tax = 8.86 ├────────┼──────┼───────┼───────┼───∙∙∙─────┤Quarters 27 .000 PMT = 20 VB = 686.05% periodic rate.4%.2 rd = 4.04%) = 9.000) = $35. FV = 1.04%.09)(1 .20%.2(2) = 8.322 (5. 26 WACC = 0. Plug these values into the WACC equation and solve: WACC = [(0. Wd = $35. b.322 = 32.4(6%) + 0.2%.04%. PV = -1. we can use the SML equation. Market value of debt = Vd = $889. Output: I = 3. To solve for rs.I=4.20%(1 .5%) + 0.0635 + (0.50(40.5(15. PMT = 20. WACC Answer: a Diff: M WACC = [(0. So rs = 0.3585. 25. a. Solve for rd = 9%.0.58) = 0.83%.3)(0.1135 .7)(0.1(12. WACC WACC = 0.

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