FMP/FINANCIAL MANAGEMENT

Lecture 4 and 5 Cost of Capital

Q No.1

Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent. What is its
WACC?

Security Market value required return

Debt $ 20 million 6%

Preferred stock 10 8%

Common stock 50 12%

Q No.2

A company has issued 10 year bond a year ago at par value with a coupon rate of 9%, paid annually.
Today the bond is selling at 1150. Firm is in the tax bracket of 40%. Company has preferred stock on
which dividend is fixed $ 4 and market price of preferred stock is $ 45. Company issued common stock,
dividend currently paid $2 which is expected to grow at a rate of 4% and stock is selling at $ 25. If
company is planning to invest in a project at a ratio of 40:20:40. What should be weighted average cost
of capital of this project?

Q No.3

Find the WACC of Naveed Computers. The total book value of the firm’s equity is $12 million; book value
per share is $22. The stocks sell for a price of $32 per share, and the cost of equity is 16 percent. The
firm’s bonds have a face value of $6 million and sell at a price of 110 percent of face value. The yield to
maturity on the bond is 9 percent, and the firm’s tax rate is 40 percent.

Q No.4 Cost Of Equity

David Ortiz 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.
Ortiz’s CFO has calculated the company’s WACC as 9.96 percent. What is the company’s cost of equity
capital?

Q No. 5 Cost of preferred stock

Tunney Industries can issue perpetual preferred stock at a price of $50 a share. The issue is expected to
pay a constant annual dividend of $3.80 a share. The flotation cost on the issue is estimated to be 5
percent. What is the company’s cost of preferred stock, kps?
Q No.6 Cost of Equity

Javits& Sons common stock is currently trading at $30 a share. The stock is expected to pay a dividend of
$3.00 a share at the end of the year (D1= $3.00), and the dividend is expected to grow at a constant rate
of 5 percent a year. What is the cost of common equity?

Q No.7 Cost of Equity

The earnings. Dividends, and stock price of Carpetto Technologies Inc, are expected to grow at 7 percent
per year in the future. Carpetto’s common stock sells for $23 per share, its last dividend was $2.00, and
the company will pay a dividend of $2.15 at the end of the current year.

a. Using the discounted cash flow approach. What is its cost of equity?
b. If the firm’s beta is 1.6, the risk –free rate is 9 percent, and the expected return on the market is
13 percent, what will be the firm’s cost of equity using the CAPM approach?

Q No.8 Calculation of g and EPS

Sidman Products stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share
this year and to pay a year-end dividend of $3.60.

a. If investors require a 9 percent return, what rate of growth must be expected for Sidman?
b. If Sidman reinvests earnings in projects with average returns equal to the stocks expected rate
of return, what will be next year’s EPS?

Q No. 9 WACC Estimation

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the
company plans to raise and invest $30 million in new projects. The firm’s present market value capital
structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt $30,000,000

Common Equity 30,000,000

Total capital $60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently
selling at $30 a share. Stockholders required rate of return is estimated to be 12 percent, consisting of a
dividend yield of 4 percent and an expected constant growth rate of 8 percent. (The next expected
dividend is $1.20, so $1.20/$30 = 4 %.) The marginal corporate tax rate is 40 percent.

a. To maintain the present capital structure, how much of the new investment must be financed
by common equity?
b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital
structure without issuing additional shares of equity. What is the WACC?
 c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of
stock. Qualitatively speaking, what will happen to the WACC?

Q No. 10 Market Value Capital Structure

Suppose the shoof company has this book value balance sheet;

Current assets $30,000,000 Current Liabilities $10,000,00

Fixed assets 50,000,000 Long term debt 30,000,000

Common equity

Common stock (1 million shares) 1,000,000

Retained earnings 39,000,000

Total assets 80,000,000 Total claims 80,000,000

The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10
percent, the same as the rate on new bank loans. The long term debt consists of 30,000 bonds, each of
which has a par value of $1000, carries an annual coupon interest rate of 6 percent, and matures in 20
years. The going rate of interest on new long-term, rd, is 10 percent, and this is the present yield to
maturity on the bonds. The common stock sells at a price of $60 per share. Calculate the firm’s market
value capital structure.

Q No.11

The following tabulation gives earnings per share figures for Exxon manufacturing during the preceding
10 years. The firm’s common stock, 140,000 shares outstanding, is now selling for Rs.50 a share, and the
expected dividend for the coming year i.e. 2002 is 50 percent of EPS for the year. Investors expect past
trends to continue, so g may be based on the historical earnings growth rate.

Year EPS
1992 Rs.2
1993 2.16
1994 2.33
1995 2.52
1996 2.72
1997 2.94
1998 3.18
 1999 3.43
2000 3.70
2001 4.00

The current interest rate on new debt is 8 percent. The firm’s marginal tax rate is 40 percent. The firm’s
market value capital structure, considered to be optimal, is as follows:

Debt Rs. 3,000,000

Common equity 7,000,000

1. Calculate the firm’s after tax cost of new debt and of common equity, assuming new equity
comes only from reinvested cash flow ( assuming constant growth rate )
2. Fine the firm’s WACC, assuming no new common stock is sold.
Student Practice

Q No. 1

Longstreet Communication Inc. has the following capital structure, which it considers to be optimal: debt 25%,
preferred stock 15% and common stock 60%.

Tax rate is 40% and investors expect earnings and dividends to grow at a constant rate of 6% in future. Company
paid a dividend of Rs.3.6 per share last year and its stock currently sells at a price of Rs.60 per share. Risk free rate
is 6%, market risk premium is 5% and company stock beta is 1.3.

New preferred could be sold to the public at a price of Rs.100 per share, with a dividend of Rs.9. Flotation costs of
Rs.5 per share would be incurred.

Debt could be sold at a interest rate of 9%.

Required:

1. Find the component costs of debt, preferred stock, and common stock.
2. Calculate WACC.
3. If company decided to change capital structure as follows: debt 35%, preferred stock 15% and common
stock 50%. Assume same component cost as you computed in part 1. Should company change its capital
structure? give reason.

Q No.2 After Tax Cost of Debt

Calculate the after-tax cost of debt under each of the following conditions:

a. Interest rate, 13 percent; tax rate, 0 percent.

b. Interest rate, 13 percent; tax rate, 20 percent.
c. Interest rate, 13 percent; tax rate, 35 percent.

Q No.2 After Tax Cost of Debt

The Heuser Company’s currently outstanding 10 percent coupon bonds have a yield to maturity
of 12 percent. Heuser believes it could issue at par new bonds that would provide a similar yield
to maturity. If its marginal tax rate is 35 percent, what is Heuser’s after-tax cost of debt?

Q No.3 Cost of preferred stock

Trivoli Industries plans to issue some $100 par preferred stock with an 11 percent dividend. The stock is
selling on the market for $97.00, and Trivoli must pay flotation costs of 5 percent of the market price.
What is the cost of the preferred stock for Trivoli?
Q No.4 After Tax Cost of Debt

A company’s 6 percent coupon rate, semiannual payment, $1,000 par value bond which matures in 30
years sells at a price of $515.16. The company’s federal-plus state tax rate is 40 percent. What is the
firm’s component cost of debt for purposes of calculating the WACC?

Q No.5 Cost of Equity

The Bouchard Company’s current EPS is $6.50. It was $4.42 5 years ago. The company pays out 40
percent of its earnings as dividends, and the stock sells for $36.

a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.)
b. Calculate the next expected dividend per share, D1 (Do = 0.4($6.50) = $2.60.) Assume that the
past growth rate will continue.
c. What is the cost of equity rs, for the Bouchard Company?