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Discussion of cost of capital

- Estate of Henry P. Lammerts, Deceased, and Cross-Appellants v. Commissioner of Internal Revenue, and Cross-Appellee. Hildred K. Lammerts v. Commissioner of Internal Revenue, 456 F.2d 681, 2d Cir. (1972)
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Viduka Constructions CFO has collected the following information to estimate the

companys WACC:

The company currently has 20-year, 8.5% annual coupon bonds that have a face value of

$1,000 and sell for $945.

The companys stock has a beta = 1.20.

The market risk premium, RPM , equals 5%.

The risk-free rate is 6%.

The company has outstanding preferred stock that pays a $2.00 annual dividend. The

preferred stock sells for $25 a share.

The companys tax rate is 40%.

The companys capital structure consists of 40% long-term debt, 40% common stock,

and 20% preferred stock.

a. 7.95%

b. 8.12%

c. 8.59%

d. 8.67%

D2.

Anderson Company has four investment opportunities with the following costs (paid at t =

0) and expected returns:

Expected

Project Cost Return

A $2,000 16.0%

B 3,000 14.5

C 5,000 11.5

D 3,000 9.5

The company has a target capital structure that consists of 40% common equity, 40% debt,

and 20% preferred stock. The company has $1,000 in retained earnings. The company

expects its year-end dividend to be $3.00 per share (D1 = $3.00). The dividend is expected

to grow at a constant rate of 5% a year. The companys stock price is currently $42.75. If

the company issues new common stock, the company will pay its investment bankers a

10% flotation cost.

The company can issue corporate bonds with a YTM of 10%. The company has a 35% tax

rate. How large can the cost of preferred stock be (including flotation costs) and it still be

profitable for the company to invest in all four projects?

a. 7.75%

b. 8.90%

c. 10.46%

d. 11.54%

D3.

Heavy Metal Corp. is a steel manufacturer that finances its operations with 40% debt, 10%

preferred stock, and 50% equity. The interest rate on the companys debt is 11%. The

preferred stock pays an annual dividend of $2 and sells for $20 a share. The companys

common stock trades at $30 a share, and its current dividend (D0) of $2 a share is

expected to grow at a constant rate of 8% per year. The flotation cost of external equity is

15% of the dollar amount issued, while the flotation cost on preferred stock is 10%. The

company estimates that its WACC is 12.30%. Assume that the firm will not have enough

retained earnings to fund the equity portion of its capital budget. What is the companys tax

rate?

a. 30.33%

b. 32.86%

c. 35.75%

d. 38.12%

D4.

Sun State Mining Inc., an all-equity firm, is considering forming a new division that will

increase the firms assets by 50%. Sun State currently has a required return of 18%, U.S.

Treasury bonds yield 7%, and the market risk premium is 5%. If Sun State wants to reduce

its required return to 16%, what is the maximum beta coefficient the new division could

have?

a. 2.2

b. 1.0

c. 1.8

d. 1.6

D5.

Arizona Rock, an all-equity firm, currently has a beta of 1.25. The risk-free rate, r RF, is 7%

and the market risk premium, RPM, is 7%. Suppose the firm sells 10% of its assets with

beta equal to 1.25 and purchases the same proportion of new assets with a beta of 1.1.

What will be the firms new overall WACC, and what rate of return must the new assets

produce in order to leave the stock price unchanged?

a. 15.645%; 15.645%

b. 15.750%; 14.700%

c. 15.645%; 14.700%

d. 15.750%; 15.645%

D6.

Bradshaw Steel has a capital structure with 30% debt and 70% common equity. The YTM

on the companys long-term bonds is 8%, and the firm estimates that its overall composite

WACC is 10%. The firm uses the CAPM to determine its cost of equity. The risk-free rate

is 5.5%, the market risk premium is 5%, and the companys tax rate is 40%. What is the

beta on Bradshaws stock?

a. 1.07

b. 1.48

c. 1.31

d. 1.35

D7.

Kenforest Grocers managers are determining the companys optimal capital budget

for the next year. Kenforest is considering the following projects:

Rate of

Project Size Return Risk

A $200,000 16% High

B 500,000 14 Average

C 400,000 12 Low

D 300,000 11 High

E 100,000 10 Average

F 200,000 10 Low

G 400,000 7 Low

The company estimates that its WACC is 11%. All projects are independent. The company

adjusts for risk by adding 2% to the WACC for high-risk projects and subtracting 2% from the

WACC for low-risk projects. Which of the projects will the company accept?

a. A, B, C, E, F

b. B, D, F, G

c. A, B, C, E

d. A, B, C, F

D8.

Grateway Inc. has a WACC of 11.5%. Its target capital structure is 55% equity and 45% debt.

The company has sufficient retained earnings to fund the equity portion of its capital budget.

The before-tax cost of debt is 9%, and the companys tax rate is 30%. If the expected

dividend next period (D1) is $5 and the current stock price is $45, what is the companys

growth rate?

a. 2.68%

b. 3.44%

c. 4.64%

d. 6.75%

D9.

Clark Communications has a capital structure that consists of 70% common stock and 30%

long-term debt. In order to calculate Clarks WACC, an analyst has accumulated the

following information:

The company currently has 15-year, 8% annual coupon bonds that have a face value of

$1,000 and sell for $1,075.

The risk-free rate is 5%.

The market risk premium is 4%.

The beta on Clarks common stock is 1.1.

The companys retained earnings are sufficient so that they do not have to issue any

new common stock to fund capital projects.

The companys tax rate is 38%.

a. 5.93%

b. 7.40%

c. 7.91%

d. 8.07%

D10.

Dobson Dairies has a capital structure consisting of 60% debt and 40% common stock.

The companys CFO has obtained the following information:

The companys common stock is expected to pay a $3.00 dividend at year end

(D1 = $3.00), and the dividend is expected to grow at a constant rate of 7% a

year. The common stock currently sells for $60 a share.

Assume the firm will be able to use retained earnings to fund the equity portion of

its capital budget.

The companys tax rate is 40%.

a. 12.00%

b. 8.03%

c. 9.34%

d. 7.68%

D11.

A company has determined that its optimal capital structure consists of 40% debt and 60%

equity. Assume the firm will not have enough retained earnings to fund the equity

portion of its capital budget, and the cost of capital is adjusted to account for flotation

costs. Given the following information, calculate the firms WACC.

rd = 8%.

Net income = $40,000.

Payout ratio = 50%.

Tax rate = 40%.

P0 = $25.

Growth = 0%.

Shares outstanding = 10,000.

Flotation cost on additional equity = 15%.

a. 7.60%

b. 8.05%

c. 11.81%

d. 13.69%

D12.

The YTM on the companys bonds is 9%.

The companys year-end dividend is forecasted to be $0.80 a share.

The company expects a constant dividend growth rate of 9% a year.

The companys stock price is $25.

The companys tax rate is 40%.

The company anticipates that it will need to raise new common stock this year,

and flotation costs will equal 10% of the amount issued.

Assume the company accounts for flotation costs by adjusting the cost of capital.

Given this information, calculate the companys WACC.

a. 10.41%

b. 12.56%

c. 10.78%

d. 13.55%

D13.

Statement 1 - The cost of a new equity issuance (k e) could possibly be lower than

the cost of retained earnings (ks) if the market risk premium and risk-free rate

decline by a substantial amount.(IC)

Statement 2 - One problem with the CAPM approach in estimating the cost of equity

capital is that if a firms stockholders are, in fact, not well diversified, beta may be

a poor measure of the firms true investment risk. (C)

continue suffering such losses, and therefore its tax rate is zero, it is possible

that its after-tax component cost of preferred stock as used to calculate the

WACC will be less than its after-tax component cost of debt. (C)

b. True, False, False

c. False, True, False

d. None of the above

D14.

Kemp Consolidated has two divisions of equal size: a computer division and a restaurant

division. Stand-alone restaurant companies typically have a cost of capital of 8 percent,

while stand-alone computer companies typically have a 12 percent cost of capital. Kemps

restaurant division has the same risk as a typical restaurant company, and its computer

division has the same risk as a typical computer company. Consequently, Kemp estimates

that its composite corporate cost of capital is 10 percent. The companys consultant has

suggested that they use an 8 percent hurdle rate for the restaurant division and a 12

percent hurdle rate for the computer division. However, Kemp has chosen to ignore its

consultant, and instead, chooses to assign a 10 percent cost of capital to all projects in both

divisions. Which of the following statements is most correct?

Statement 1 - While Kemps decision to not risk adjust its cost of capital will lead it to

accept more projects in its computer division and fewer projects in its restaurant

division, this should not affect the overall value of the company.

subsidizing its restaurant division, which means that its restaurant division is likely to

become a larger part of the overall company over time.

Statement 3 - Kemps decision to not risk adjust means that the company will accept

too many projects in the computer business and too few projects in the restaurant

business. This will lead to a reduction in the overall value of the company.

A. Statement 1 and 3

B. Statement 2 and 3

C. Statement 3 only

D. None of the above choices

D15.

shown in the table below:

Amount of Amount of Before-Tax

Arrangement Equity Raised Debt Financing Cost of Debt

#1 $700,000 $300,000 8% per annum

#2 $300,000 $700,000 10% per annum

In the first year of operations, the company is expected to have sales revenues of

$500,000, cost of sales of $200,000, and general and administrative expenses of

$100,000. The tax rate is 30%, and there are no other items on the income statement.

All earnings are paid out as dividends at year-end.

arrangement #1, to the nearest full percentage point, would be 10% (C)

II. The company will have a higher degree of operating leverage under arrangement

#2. (IC)

III. Under financing arrangement #2, the degree of financial leverage (DFL), rounded

to two decimal places, would be 1.54 (C)

A. I only

B. I and II only

C. I and III only

D. II only

Key Answers

D1. C

D2. B

D3. B

D4. B

D5. C

D6. D

D7. D

D8. C

D9. C

D10. D

D11. A

D12. A

D13. A

D14. C

D15. C

- Estate of Henry P. Lammerts, Deceased, and Cross-Appellants v. Commissioner of Internal Revenue, and Cross-Appellee. Hildred K. Lammerts v. Commissioner of Internal Revenue, 456 F.2d 681, 2d Cir. (1972)Uploaded byScribd Government Docs
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