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 . Bouchard 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

29% Medium: WACC 5 . • The company anticipates that it will need to raise new common stock this year.36% d. and the debt has a total current market value of $25 million. The company has a target capital structure of 40 percent debt and 60 percent equity.Page 2 .78% 13.55% b. What weighted average cost of capital should you use to evaluate potential projects? a. b.55% 9.67% Chapter 9 . Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued.33% c. • The company expects that its dividend will grow at a constant rate of 9 percent a year. • The yield to maturity on the company’s bonds is 9 percent. d. e. 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. 9. The yield to maturity on this debt is 11. • The company’s year-end dividend is forecasted to be $0. The tax rate is 40%. 30 percent debt.: collected the following Answer: a Diff: E information regarding • The company’s capital structure is 70 percent equity.80 a share.56% 10. • The company’s stock price is $25. is 12 percent. The balance sheets also show that that the company has 10 million shares of stock. 10. Given this information.WACC with Flotation Costs 4 . An analyst has Christopher Co. rS.5 per share. The current stock price is $7. the total of common stock and retained earnings is $30 million. 9. calculate the company’s WACC. a. • The company’s tax rate is 40 percent.41% 12. 9.11 percent.87% e. The current return required by stockholders. 8. 10. Assume the company accounts for flotation costs by adjusting the cost of capital. c.

7. e.6% 10.2% c. d. Given the following information.0% Chapter 9 . WACC 8 . The risk-free rate is 5 percent and the market risk premium (rM .20.0% b.0% 6.2% 10. rs? a. 7.0% 7.00 a.00 per share.4% Cost of common stock Answer: b Diff: M 7 . calculate the firm's weighted average cost of capital. c. The common stock of Anthony Steel has a beta of 1. What is the company’s cost of common stock. 6. e. b.Cost of common stock Answer: d Diff: M 6 . b.Page 3 . Martin Corporation's common stock is currently selling for $50 per share. rd = 6% Tax rate = 40% P0 = $25 Growth = 0% D0 = $2.2% e. c. 12.2% 7.2% 8. d.8% 11. then what is the firm's cost of common stock? a.0% d. The current dividend is $2. If dividends are expected to grow at 6 percent per year.0% 10.0% Answer: b Diff: M A company has determined that its optimal capital structure consists of 40 percent debt and 60 percent equity. 12. 10. 11.rRF) is 6 percent.

Page 4 • • • . The company's common stock currently sells for $30 a share.99% e. and no new stock will be issued. and 50 percent common stock. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. 9. • The company’s tax rate is 40 percent. • The company's dividend is currently $2. • • • The company can issue bonds at a yield to maturity of 8. What is the company’s weighted average cost of capital (WACC)? a. 8. The company’s CFO has obtained the following information: The before-tax yield to maturity on the company’s bonds is 8 percent. a current maturity of 20 years.00). 10 percent preferred stock.00). What is the company’s weighted average cost of capital (WACC)? a.03% c.WACC 9 .00 a share (D0 = $2.00% b. $100 preferred stock which pays a 12 percent annual dividend.00 dividend at year end (D1 = $3. 7. at par. 20 percent preferred stock. 13. but flotation costs of 5 percent would be incurred.15% WACC 10 . Answer: c Diff: M Johnson Industries finances its projects with 40 percent debt.33% b.) Rollins Corporation is estimating its WACC. 9. The common stock currently sells for $60 a share. 12.4 percent. • The company’s tax rate is 30 percent. The company’s common stock is expected to pay a $3. and the dividend is expected to grow at a constant rate of 7 percent a year. 9. 9. 8.34% d. and 60 percent common equity.2.32% c.68% Multiple part: (The following information applies to the next six problems.79% d. Rollins' beta is 1. • Assume that the flotation cost on debt and preferred stock is zero. The firm could sell. and is expected to grow at a constant rate of 6 percent per year. The cost of preferred stock is 9 percent. Answer: e Diff: M Dobson Dairies has a capital structure which consists of 60 percent long-term debt and 40 percent common stock.000.00% e. 8. Its bonds have a 12 percent coupon. paid semiannually. and sell for $1. the risk-free rate is 10 Chapter 9 . Its target capital structure is 20 percent debt.

and the market risk premium is 5 percent.0% 12. c. 13. 13. 9. What is the firm's cost of common stock (rs) using the DCF approach? a. WACC 16 .1% c. b.6% 14.6% 14. e. d.9% Answer: a What is Rollins' WACC? Chapter 9 .6% 16.1% 16. 13.6% 16.2% Answer: d Diff: E Answer: e Diff: M Cost of common stock: CAPM Answer: c Diff: E 13 . 10.1% 16.9% Cost of common stock: DCF Answer: c Diff: E 14 .6% 14. 10. d. What is Rollins' cost of common stock using the bond-yield-plus-riskpremium approach? a.0% 12. The firm's marginal tax rate is 40 percent. What is Rollins' component cost of debt? a.0% 16. b.9% Cost of common stock: Risk premium Answer: c Diff: E 15 . d.6% 16.Page 5 Diff: E .2% Cost of preferred stock 12 .0% 16. Cost of debt 11 . e. b. e.0% e. c. 7.00 per share. c.6% d.percent. c. sells for $27.0% 11. e. 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.00. What is Rollins' cost of preferred stock? a.1% 16. What is Rollins' cost of common stock (rs) using the CAPM approach? a. d. Rollins is a constantgrowth firm which just paid a dividend of $2. 8. b.0% 16.6% 13. and has a growth rate of 8 percent.0% b. 8.

5% 15.0% 12. e. Cost of common stock 17 . c. c.8% 11.3% 10. the firm will net only $80 per share from the sale of new preferred stock.0% 16. c. The current market price of the firm's stock is P0 = $28. 9. d.6% 16.1% 16. 10. Ross and Sons Inc. c.0% Answer: d What is the firm's weighted average cost of capital (WACC)? a. rs? a.20.0% 12. WACC 19 . and its expected growth rate is 6 percent. rps? a. d. e.4% 11. What is the firm's cost of newly issued preferred stock. Ross's common stock currently sells for $40 per share. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.5% 18. What will Allison's marginal cost of Chapter 9 . The firm recently paid a dividend of $2 per share on its common stock.5% 10. 10.0% Diff: E Answer: c Diff: E Cost of preferred stock Answer: b 18 . has a target capital structure that calls for 40 percent debt.9% Diff: E Cost of equity Answer: a Diff: M 20 . The firm expects to earn $600 in after-tax income during the coming year. d. The firm's preferred stock currently sells for $90 per share and pays a dividend of $10 per share. b. e.9% (The following information applies to the next three problems. Allison can issue new common stock at a 15 percent flotation cost. and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year.) J. and 50 percent common equity.a. What is the firm's cost of common stock. d.Page 6 . b.5% 16. The firm's current after-tax cost of debt is 6 percent. e. however. b.6% 14. and it will retain 40 percent of those earnings. its last dividend was D0 = $2. and it can sell as much debt as it wishes at this rate.5% 15. b. 13.5% 16. 10 percent preferred stock.5% 18.

• The company’s target capital structure is 75 percent equity and 25 percent debt. c. 7. e. 15.3% e. What is the company’s WACC? a.Page 7 .8% b. wants to calculate its weighted average cost of capital (WACC).9% c. The company’s CFO has collected the following information: • The company’s long-term bonds currently offer a yield to maturity of 8 percent.67% 11. d. 14. The company recently paid a dividend of $2 per share (D0 = $2.7% WACC 21 . • The company pays a 10 percent flotation cost whenever it issues new common stock (F = 10%). 10. • • The company’s stock price is $32 per share (P0 = $32).47% 12.00). • The company anticipates issuing new common stock during the upcoming year.equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital? a.56% Chapter 9 . 13.9% d. b. • The company’s tax rate is 40 percent.22% 11.02% 12. Answer: b Diff: M Hilliard Corp. • The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%). 9.

000 $19. and fertilizers. This is a position with high visibility and the opportunity for rapid advancement.000.000 $50.000. Following are balance sheets and some information about CGT.000.000 $80.000 $30.000 bonds. Assets Current assets Net plant.000.000 $139.5 percent.000.000 shares) Retained Earnings Total shareholders equity Total liabilities and shareholders equity $38. calculator required.5 percent during the past five years.Page 8 .000. styrofoam cups.000 You check The Wall Street Journal and see that CGT stock is currently selling for $7.000. and equipment Total Assets Liabilities and Equity Accounts payable Accruals Current liabilities Long term debt (40.25 percent annual coupon rate.5 percent.000 face value) Total liabilities Common Stock 10.000 $101.000. a Fortune 500 firm that is a major producer of chemicals and plastic goods: plastic grocery bags.000. providing you make the right decisions. property.000 $9.000. but the stock market has had an average annual return of 14. The beta for your company is approximately equal to 1. You are on the corporate staff as an assistant to the VicePresident of Finance. with semi-annual payments.000. The yield on a 6-month Treasury bill is 3.000.5 percent and the yield on a 20-year Treasury bond is 5. $1.000. Your boss has asked you to estimate the weighted average cost of capital for the company. Chapter 9 .50 per bond.000 $40.000 $139.) Financial You are employed by CGT.50 per share and that CGT bonds are selling for $889.000 $10.1. These bonds have a 7.000 $59. CGT is in the 40 percent tax bracket. The expected return on the stock market is 11. The bonds mature in twenty years.Financial Calculator Section Multiple Choice: Problems Medium: (The following information applies to the next four problems.

not the EAR.20% 4. Hamilton Company's 8 percent coupon rate. b. what is the best estimate of the cost of equity for CGT? a. Based on the nominal interest rate.Page 9 .6% 65. d. 3.52% 4.36% d. e.04% 5.8% 33. c.37% Weights for WACC Answer: d Diff: M 24 .35% 5. 10.26% Chapter 9 . quarterly payment.000 par value bond.60% Diff: M After-tax cost of debt Answer: d 23 .10% 12. 12.86. The company's tax rate is 40 percent.05% b. c. $1.2% 27. WACC 25 .75% 9. c.3% 32. we we we we we = = = = = 57. b.8% 72.6% Answer: e What is the best estimate of the WACC for CGT? a.83% Diff: M Component cost of debt Answer: b Diff: M 26 .40% 15. What is best estimate for the after-tax cost of debt for CGT? a. d.32% c. what is the firm's component cost of debt for purposes of calculating the WACC? a. e.4% and and and and and wd wd wd wd wd = = = = = 42.30% 15. 7. d.7% 67. c. currently sells at a price of $686. Using the CAPM approach. b. Which of the following is the best estimate for the weights to be used when calculating the WACCC? a.2% 66.92% 9.4% 34. e.65% 8.10% 12. 7. e. 2. b. 8.CAPM cost of equity Answer: b Diff: M 22 . d.18% 9. which matures in 20 years. 12.20% e.

0 (3) The current risk-free rate is 6. and the expected return on the market is 11.04% b. (2) Over the past four years. 9. 13.25% d. 12.2 -3.273.2 -7.Page 10 .00% c. 10.0 J-Mart 14. the returns on the market and on J-Mart were as follows: Year 2001 2002 2003 2004 Market 12. The bonds have a 12 percent annual coupon and currently sell at a price of $1.35 percent.8564.35 percent. The company's tax rate is 35 percent. a large retail chain: (1) The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1. 8.5% 22. Answer: a Diff: M A stock analyst has obtained the following information about J-Mart.000. What is the company's estimated weighted average cost of capital (WACC)? a.0% 17.WACC 27 .8 20.14% Chapter 9 .5 24.33% e. The company anticipates that its proposed investment projects will be financed with 70 percent debt and 30 percent equity.

Page 11 .CHAPTER 9 ANSWERS AND SOLUTIONS Chapter 9 .

3)(0.3%. Answer: b Diff: E $2. Find re: re = D1/[P0(1 .6) + (0. WACC The cost of common stock is: Answer: c Diff: M rs = D1/P0 + g = $2.2%. and rd = 0.1. 9 .06)/$20 + 0.11%) = 9.0.4)(0. WACC Find the cost of common stock: rs = D1/P0 + g = $2(1.05 = 0. rs = 0.0. WACC = 0.11%.09 = 0. Cost of common stock The rs = = = Answer: d Diff: M 7 .00%.09)(0.06 = 0. so WACC = (D/A)(1 .06 = 0.87%.4) (11.125556.06% = 10.4 (1-.41%.06 = 13.2%.00(1.F)] + g = $0.0)/$25 + 0%. WACC with Flotation Costs Answer: a Diff: E WACC = wdrd(1 . cost of common equity as calculated from the CAPM is rRF + (rM .2%.8/[$25(1 .60 (12%) + 0. $50 Answer: e Diff: E Cost of common stock rs = $0. calculate WACC.4(1 .2%.08. Cost of common stock The cost of common stock is: Answer: d Diff: E rs = $1(1.2 12.06) + 0.0 6) + 0.053 + 0.1)] + 0. .T) + wcere. $5 0 Answer: b Diff: M 8. 2. Finally.00(1.125556) = 10. rd is given = 9%. Answer: b Diff: M Cost of common stock rs = $2.24% ≈ 10. 6.59 4.7)(0.06. Now you can calculate WACC: WACC = (0.07%. $8.rRF)b 5% + (6%)1. 5.05 ) + 5% = 9. WACC Answer: d Diff: M Weights should be based on the target capital structure: wd = 40% and we = 60%.6(0.08) = 0. Cost of common stock rs = 3.0624 ≈ 6. The cost of debt should be based on the yield of 11.Tax rate)rd + (E/A)rs = 0. using rs = 0.12/$30 + 0.08 = 8%.05) + 0.113 = 11.90(1.1600 = 16.

Financial calculator solution: Inputs: N = 40.0.0%(0.7) = 5.2%. Cost of debt Time line: 0 rd / 2 = ? 1 11.88%) + 0.0%(1 .08)(1 . WACC should be calculated using rs.12) = 0. The after-tax cost of debt equals: rd.0%.6)(0. the before-tax cost of debt to Rollins is 12 percent.07%) = 9.07 = 0. Output: I = 6.4%(0. rd(1 . 12. 13 .4(5. 14.000 2 3 4 Since the bond sells at par of $1.68%. 10. its YTM and coupon rate (12 percent) are equal. WACC Answer: e Diff: M The firm will not be issuing new equity because there are adequate retained earnings available to fund available projects. Answer: e Diff: M 40 6-month ├───────────┼─────┼────────┼─────────┼───∙∙∙───────┤ Periods PMT = 60 VB = 1.The cost to the company of the bonds is the YTM multiplied by 1 minus the tax rate: rd = YTM(1 .95) = 12.T) = 12.79%.40) = 7.0%. rd = 6.5(13. The weighted average cost of capital is then WACC = wd(rd) + wps(rps) + wce(rs) WACC = 0.88%. $27 .6) = 7.6%.1(9%) + 0.000.T) = 8. The cost of the preferred is given as 9%.00 + 0.After-tax = 12.2%.0% = rd/2. Cost of common stock: DCF Cost of common stock (DCF approach): rs = 15 Answer: c Diff: E Answer: d rps = $12/$100(0.4) + (0.12 = 12%.000. Answer: c Diff: E Diff: E $2. Therefore. PMT = 60. WACC = wdrd(1 .T) + wcers = (0.000 60 60 60 60 FV = 1.08) + 8% = 16.00(1.0% × 2 = 12%.0768 = 7. Cost of preferred stock Cost of preferred stock: Cost of common stock: CAPM Cost of common stock (CAPM approach): rs = 10% + (5%)1. FV = 1.4)(0.0. Thus. rs = D1/P0 + g = $3.2 = 16. PV = -1.00/$60.000.

1579 ≈ 15. Cost of common stock rs = 18.15) P0 ( 1 − F ) = 0.0.4) + 0.00(1.25(0. WACC = Wd(rd)(1 .56% ≈ 13.06 = 0.5%-5.T) + wce(re) = 0.10 = 15. CAPM Cost of Equity rs = 5. As there are no retained earnings.6 = $400. Answer: c Diff: E $2. capital budget exceeds Break pointRE.22%.5% + 1. 11.5%.00 Answer: b Diff: E Cost of preferred stock rps = $10 $80 = 12.06)/($32(1 . After-tax cost of debt N=40 I=? PV=-889. Dividend payout = 0.50 PMT=36.6.25 FV=1.6. the equity portion of the capital budget must be funded using new common equity. WACC Cost of equity Calculate the retained earnings break point: Given: Net income = $600.06 $28( 1 − 0. Equity = 0. Use the dividend growth model to calculate re: re = D0 ( 1 + g) $2. 23.06] = 0. 16 .10%.6) + 0.6)/0. Debt = 0. WACC Answer: a Diff: E WACC = wdrd(1 .1(11.T) + wpsrps + wcers = 0.0%)(0. WACC Answer: b Diff: M The correct answer is b.2(12. Answer: d Answer: a Diff: E Diff: M 19.0.0% = 16.6(16.5%.0%. Break pointRE = $600(1 .0%) = 13.20( 1.4.25(0. 21.75(0.1)) + 0.10) + 0. $40.. 20 .6%. Cost of common stock: Risk premium Answer: c Diff: E Cost of common stock (Bond yield-plus-risk-premium approach): rs = 12.0979 + 0.75[($2.2(12.1336) = 0.1122 = 11.06) + g = + 0.6%) + 0.0% + 4. 17 .0480) + 0.5%) = 12. 22.00 x 1.8%.0.22%. Allison will need new equity capital.08)(1 .000 Answer: d Diff: M Answer: b Diff: M .

05% × 4 = 12.1314 = 13. We = $75/($75+$35. 25.2(2) = 8.I=4.58) = 0.000.7)(0.50(10 million) = $75 million. Component cost of debt Time line: 0 rd = ? = wdrd(1 . b.8%. since target values are not available.04%) = 9.4%. Financial calculator solution: Calculate the nominal YTM of bond: Inputs: N = 80. Weights for WACC Answer: d Diff: M Use market values for estimating the weights.50(40.AT = 12. c.5(15.4%(1-0.10%) + 0.1135 . To solve for rs. PMT = 120. Plug these values into the WACC equation and solve: WACC = [(0. PV = -686.273. we can use the SML equation.0635 + (0.3585. 24.3)(rs)].0635)(1.4(6%) + 0.20%.0. rd after-tax = 8.000) = $35. WACC WACC = 0. So rs = 0.09)(1 .4) = 7.5%) = 11. FV = 1.4%. Market value of equity = Ve = $7.58 million.1(12. FV = 1.58) = 0. Nominal annual rate = 3.32%.0.7)(rd)(1 .T)] + [(0.35)] + [(0.58/($75+$35.3)(0. .000.3585) = 0. Answer: b Diff: M 1 2 20 3 20 4 20 80 20 FV = 1.86 ├────────┼──────┼───────┼───────┼───∙∙∙─────┤Quarters 27 .2 rd = 4. Solve for rd = 9%.05% periodic rate.5%) + 0.20%(1 . 26 WACC = 0. Output: I = 3.0804 = 8.04%.20%(1 .678 = 67.1314)] = 0.14%.000 PMT = 20 VB = 686.83%. Using Market and J-Mart return information and a calculator's regression feature we find b = 1.86.322 (5.04%.2%.322 = 32.40) = 5.T) + wpsrps + wcers Answer: e Diff: M . Use bond information to solve for rd: N = 20. Wd = $35.678 (12.T) = 12. but we need to find beta. PV = -1. a. Calculate rd after-tax: rd. Market value of debt = Vd = $889.8564. WACC Answer: a Diff: M WACC = [(0.0. PMT = 20.

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