TOPIC 4: COST OF CAPITAL answers

Question 1

Tanya Industries is planning to sell a new 12% bond maturing in 15 years at RM1,000
each. Each bond has a flotation charge of RM30. If the firm's tax rate is 34%, what is
the approximate after-tax cost of new bonds?

kd = $120 + ($1000 – $970)

15
($1000 + $970)
2

= $122 / $985

= 12.39%

After-tax cost of new debt (Kd) = 12.39% (1-34%)

= 8.18%

Question 2

Yippee Jewelers is trying to determine its cost of debt. The firm has debt issue
outstanding with 12 years to maturity that is quoted at net price RM1040. The issue
makes annual payment and has embedded cost of 8% annually from par value. What is
Yippee’s pre-tax cost debt? If the company’s tax rate is 35%, what is the after tax cost of
debt?

n=12 MV=1040 C=8 % x 1000= 80 T=35%

kd = $80 + ($1000 – $1040)

12
($1000 + $1040)
2
= 7.52%

After-tax cost of new debt (Kd) = 7.52% (1-35%)

= 4.89%

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Question 3
Malaysian Corp plans to issue 25 year, 9% c o u p o n bond ( p a i d semiannually)
with a flotation cost of RM12 per unit. Calculate the after tax cost of debt if the
current market value for the bond is RM980. Tax rate is fixed at 28%.

n = 25x2 C =9% x 1000 x ½ FV =12 MV =980

= 50 = 45 Net MV = 980-12= 968

kd = $45 + ($1000 – 968)

50
($1000 + $968)
2
= 4.64%
(semiannually)
= 9.28% (annually)

After-tax cost of new debt (Kd) = 9.28% (1-.28)

= 6.68%

Question 4

The Mountaineer Airline Company has consulted with its investment bankers and
determined that they could issue new debt with a yield of 8%. If the corporate tax rate is
39%, what is the after-tax cost of debt to Mountaineer?

kd= 0.08 (1 – 0.39) = 0.0488 or 4.88%

Question 5

Douglas Oil & Gas has an opportunity to sell new preferred stock for RM50 per share
that pays a RM4.50 annual dividend. If each share has a RM2.50 flotation charge, what
will be the cost of new preferred stock to the firm?

kps = $4.50/$47.50
= 9.47%

Question 6

Gaga Publisher has an issue of preferred stock with RM48 stated dividend that just sold
for net price RM726 per share. What is the bank’s cost of preferred stock?

kps = 48/726
= 6.62%
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Question 7

Guppy Inc. is planning to issue another series of preferred stock with RM52 of annual
dividend that will be sold at RM737. The flotation cost is RM88. What is the cost of
preferred stock?

kps = 52/(737-88)
= 8.01%

Question 8

Use the following data for Textilease, Inc. to solve questions 8

Current market price per share RM40.00

The most current dividends per share RM2.50
Earnings per share RM6.00
Flotation costs per share for sale of new common stock RM3.00
Beta on the firm's common stock 0.95
Expected return on the market 13%
Risk-free rate 5%
Interest rate on AAA bonds 10%
Firm's historical growth rate in dividends 6%

a) If the firm expects its growth rate to continue, what is the cost of retained
earnings using the constant growth model?
b) What is the cost of new common stock, using the constant growth model?
c) What is the cost of retained earnings for Textilease, Inc., using the Capital Asset
Pricing Model (CAPM)?

a) Cost of retained earnings or internal equity: Kcs = ($2.65 / $40) + 0.06

=12.63%

b) Cost of new common stock or external equity: Kcs = [$2.65 / ($40 - $3)] + 0.06
=13.16%

c) Cost of retained earnings by using CAPM formula = Krf + ß(Km –Krf)

= 0.05 + 0.95(0.13 – 0.05)
= 12.60%

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Question 9

Malta Berhad just issued a dividend of RM0.42 per share on its common stock. The
company is expected to maintain a constant 6% growth rate in its dividend indefinitely.
If the stock sells for RM6.50 a share (net price), what is the company’s cost of new
common stock?

Ksc = D1 + g
NP0
= 0.42 (1.06) + 0.06 = 12.85%
6.50

Question 10

Assume that Teleko’s common stock has a beta of 1.2. If the risk-free rate is 4.5% and
expected return on the market is 13%, what is Teleko’s cost of equity?

Ksc = krf + B (km – krf)

= 4.5 + 1.2 (13 – 4.5)
= 14.7%

Question 11
Martin Enterprise has compiled the following information about its capital structure and
estimated costs of new financing:
Source of Capital Book Value (RM) Market Value (RM) After-tax cost (%)
Long-term debt 2,000,000 1,800,000 7
Preferred Stock 500,000 600,000 12
Common Equity 1,500,000 3,600,000 16

The company expects to have a significant amount of retained earnings available and
does not expect to sell any additional common stock.

a) What is the firm's WACC, using book value weights?

b) What is the firm's WACC, using market value weights?

a) WACC = 0.500 (0.07) + 0.125(0.12) + 0.375(0.16) = 11%

b) WACC = 0.30(0.07) + 0.10(0.12) + 0.60(0.16) = 12.90%

Question 12

Tut-tut Manufacturing has a target debt ratio of 35%. Its cost of equity is 18% and its
after-tax cost of debt is 10%. If the tax rate is 30%, what is Tut-tut’s WACC?

WACC = 0.35 [(10%) (1-.30)] + 0.65 (18%)

= 14.15%

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 Question 13
Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. The
corporate tax rate is 35%. In consultation with investment bankers, Gaggle expects to be able to:

Issue new debt:

• at par with a coupon rate of 8%.
• investors expect an 8% return.
• debt cost before tax is 8%

Issue new preferred stock:

• with a RM2.50 per share dividend
• net price of RM25 a share.

Utilise internal funds:

• the market price of common stock is RM20.00 a share.
• Gaggle expects to pay a dividend of RM1.50 per share next year.
• Market analysts foresee a growth in dividends in Invest stock at a rate of 5% per year.

Gaggle' marginal tax rate is 35%.

a) If Gaggle raises capital using 45% debt, 5% preferred stock, and 50% common
stock, what is Gaggle's cost of capital?
b) If Gaggle raises capital using 30% debt, 5% preferred stock, and 65% common
stock, what is Gaggle’s cost of capital?

kd= 0.08 (1 – 0.35) = 0.52 or 5.2%

kps = $2.50 / $25 = 10%
kcs = $1.50 / $20 + 5% = 7.5% + 5% = 12.5%

a. WACC = [0.45 (0.052)] + [0.05 (0.10)] + [0.50

(0.125)]
WACC = 0.0234 + 0.005 + 0.0625
WACC = 0.0909
WACC = 9.09%
This means for every $1 Gaggle raises from investors, it must pay its investors
almost $0.09 in return.

b. WACC = [0.30 (0.052)] + [0.05 ( 0.10)] + [0.65 (0.125)]

WACC = 0.0156 + 0.005 + 0.08125
WACC = 0.10185
WACC = 10.185%
This means for every $1 Gaggle raises from investors, it must pay its investors
almost $0.10 in return.

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 Question 14

Peak Manufacturing Company has the following capital structure stated in book value terms:

Source of Capital RM
Bonds (RM1,000 par, 8.5% coupon) 3,000,000
Preferred stock (25,000 shares at RM20 500,000
par)
Common stock (200,000 shares 200,000
outstanding at RM1 par)

The firm's bonds are currently selling for RM965 per bond, the preferred stock for RM18 per share,
and the common stock for RM40 a share. What is the market value of each source of capital and
the current total value of the firm (total financing needed based on market value)?

Bond $3mill /$1000 = 3,000 bonds x $965 = $2.895 mill

Preferred Stock 25,000 shares x $18 = $450,000
Common stock 200,000 shares x $40 = $8 mill
TOTAL = $11,345,000

Question 15

A firm currently has the following capital structure which it views as optimal.

DEBT: RM 3,000,000 par value of 9 percent bonds outstanding with an annual before-tax cost of
debt of 7.97 percent on a new issue. T he bonds currently sell for RM 1150 per RM 1000 par value.

COMMON STOCK: 46,000 shares outstanding currently selling for RM 50 per share. The firm
expects to pay a RM 5.00 dividend per share one year from now and is experiencing a 3.97 percent
growth rate in dividends, which it expects to continue indefinitely.

The corporate tax rate is 40 percent, and it expects to be able to finance all new projects with debt
and internal common equity.

i. Define the term cost of capital.

The CoC is the rate that must be earned on an investment project if the project is to increase
the value of the common stock’s investment.

ii. Calculate the current total value of the firm (total financing needed based on market value)

BOND: (RM3,000,000/RM1000) = 3,000 units

3,000 units X RM1150 = RM3,450,000

COMMON STOCK: 46,000 units X RM50 = RM2,300,000

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CURRENT TOTAL VALUE = RM3,450,000 + RM2,300,000
= RM5,750,000

iii. What is the proportion of debt in this firm’s capital structure?

RM3,450,000 / RM5,750,000 = 60%

iv. Calculate the after-tax cost of debt.

AT = 7.97% X (1- 0.4)

= 4.782%

v. Calculate the cost of common stock.

Kcs = (RM5/RM50) + 3.97% = 13.97%

vi. What is the firm’s weighted average cost of capital (WACC)?

(60% X 4.782%) + (40% X 13.97%) = 8.4572%

TRUE or FALSE

1) The cost of capital is the minimum rate of return required by the investors
supplying the funds.

2) The cost of capital helps establish a benchmark return that the company must
achieve to satisfy its debt and equity investors

3) There are no free sources of permanent financing.

4) The after-tax cost of debt is generally more expensive than the cost of
common equity.

5) Flotation costs increase the cost of issuing new securities.

6) The cost of preferred stock is equal to the rate of return required by preferred
stockholders multiplied by (1 - tax rate).

7) The WACC is the sum of each specific cost of capital divided by the total
number of different types capital.

8) If a firm were financed entirely by bonds or other loans, its cost of capital
would be equal to its cost of debt. Conversely, if the firm were financed
entirely through common or preferred stock issues, then the cost of capital
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 would be equal to its cost of equity.

9) Defining the cost of capital takes into account two general perspectives: the
required rate of return of the lender and the weighted average cost of capital
for the borrower.

10) The default rate of return attached to a ‘risk free’ asset, such as a treasury
bond. While nothing is completely risk free, these assets are as close to
minimal risk as possible and represent the lowest practical rate of return.

11) An additional amount of capital that changes the WACC is referred to as a

break point. This is the point at which the cost of one of the sources of capital
changes.

12) Break Point = (Amount of Capital at which Sources Cost of Capital Changes) X
(Proportion of New Capital Raised from the Source)

TRUE (T) or FALSE (F)

1) T
2) T
3) T
4) F
5) T
6) F
7) F
8) T
9) T
10) T
11) T
12) F