Exam III – Review I Soln.

1. Suppose you are an analyst with the following data: rRF = 5.5%; rM - rRF = 6%;
b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; rd = firm’s bond yield = 6.5%. What is
this firm’s cost of equity using the CAPM, and DCF methods.
CAPM = rRF + b (rM – rRF)
CAPM = 5.5 + (0.8) (6)
CAPM = 10.3%

DCF = rs = (D1/ Po) + g

DCF = (1.00/25.00) + .06
DCF = .04 + .06
DCF = 10%

2. A firm has common stock with D1 = $1.50; P0 = $30; g = 5%; and F = 4%. If the
firm must issue new stock, what is its cost of issuing new external equity?
(10.21%)
Re = [D1/Po (1-F)] + g
Re = [1.50/ 30 (1-.04)] + 0.05
Re = 10.21%

3. A firm has the following data: Target capital structure of 46 percent debt, 3
percent preferred, and 51 percent common equity; Tax rate = 40%; rd = 7%; rp =
7.5%; and rs = 11.5%. Assume the firm will not be issuing new stock. What is this
firm’s WACC?
WACC = (wd)(rd)(1 – T) + (wc)(rc) + (wp)(rp)
WACC = (.46) (.07) (1-.40) + (.51) (.115) + (.03) (.075)
WACC = 0.01932 + 0.05865 + 0.00225
WACC = 0.08022 = 8%

4. Percy Motors has a target capital structure of 40 percent debt and 60 percent
equity. The yield to maturity on the company’s outstanding bonds is 9 percent,
and the company’s tax rate is 40 percent. Percy’s CFO has calculated the
company’s WACC as 9.96 percent. What is the company’s cost of common
equity?
A. 11%
B. 12%
C. 13%
D. 14%
40% Debt; 60% Common equity; rd = 9%; T = 40%; WACC = 9.96%; rs
=?
WACC = (wd)(rd)(1 – T) + (wc)(rs)
0.0996 = (0.4)(0.09)(1 – 0.4) + (0.6)rs
0.0996 = 0.0216 + 0.6rs
0.078 = 0.6rs
rs = 13%.
 5. Hook Industries has a capital structure that consists solely of debt and common
equity. The company can issue debt at 11 percent. Its stock currently pays a $2
dividend per share and the stock’s price is currently $24.75. The company’s
dividend is expected to grow at a constant rate of 7 percent per year; its tax rate is
35 percent; and the company estimates that its WACC is 13.95 percent. What
percentage of the company’s capital structure consists of debt financing?
A. 16%
B. 18%
C. 20%
D. 22%
rs = D1/P0 + g = $2(1.07)/$24.75 + 7%
= 8.65% + 7% = 15.65%.
WACC = wd(rd)(1 – T) + wc(rs); wc = 1 – wd.
13.95% = wd(11%)(1 – 0.35) + (1 – wd)(15.65%)
0.1395 = 0.0715wd + 0.1565 – 0.1565wd
-0.017 = -0.085wd
wd = 0.20 = 20%.

6. Project K has a cost of $52,125, its expected net cash inflows are $12,000 per year
for 8 years, and its cost of capital is 12 percent. What is the project’s NPV?
A. $7,486.68*
B. $7,753.78
C. $8,368.46
D. $8,621.88

7. Using the above information, what is the project’s IRR?

A. 14%
B. 15%
C. 16%*
D. 17%

8. Your rich aunt wants to retire in 20 years but is unsure of how much to invest now
so that she can have $2,000,000 as a retirement fund. She is currently looking into
markets that yield 8%. Calculate how much she should invest now.
N = 20, I/Y = 8, PV = -429,096, PMT = 0, FV = 2,000,000

9. Suppose you borrowed $40,000 on a student loan at a rate of 9%

and must now repay it in three equal installments at the end of
each of the next three years. How large would your payments be,
how much of the first payment would represent interest, how
much would be principal, and what would your ending balance
be after the first year?
N = 3, I/Y = 9, PV = -40,000, PMT = 15,802.1903, FV = 0
Balance at Year 1 end = 27,797.8097
Interest at Year 1 end = 3,600.00
Principal at Year 1 end = 12,202.1903

10. Pearson Brothers recently reported an EBITDA of $8.5 million and $1.9 million
of net income. The company has $2.5 million of interest expense and the
corporate tax rate is 40%. What was the company’s depreciation and amortization
expense?
A. $3,166,667
B. $2,833,333 *
C. $1,833,333
D. $1,266,667
EBITDA 8,500,000
DA 2,833,333
EBIT 5,666,667
I 2,500,000
EBT 3,166,667
Taxes 1,266,667
NI 1,900,000