Tutorial 6: The cost of capital

1. After –tax cost of debt The Heuser Company’s currently outstanding bonds have a 10
percent coupon and a 12 percent yield to maturity. Heuser believes it could issue new bonds
at par 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?

2. Cost of preferred stock Tunney Industries can issue perpetual preferred stock at a price of
$47.50 a share. The stock would pay a constant annual dividend of $3.80 a share. What is the
company’s cost of preferred stock, rp?

3. Cost of common equity Percy Motors has a target capital structure of 40 percent debt and
60 percent common equity, with no preferred stock. The yield to maturity on the company’s
outstanding bonds is 9 percent, and its tax rate is 40 percent. Percy’s CFO estimates that the
company’s WACC is 9.96 percent. What is Percy’s cost of common equity?
4. Cost of common equity The earnings, dividends, and common 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 it will pay a dividend
of $2.14 at the end of the current year.

a. Using the DCF approach, what is its cost of common equity?

b. If the firm’s beta is 1.6, the risk-free rate is 9 percent, and the average return on the market
is 13 percent, what will be the firm’s cost of common equity using the CAPM approach?

c. If the firm’s bonds earn a return of 12 percent, what will rs be based on the bond-yield-
plus-risk-premium approach, using the midpoint of the risk premium range?

d. Assuming you have equal confidence in the inputs used for the three approaches, what is
your estimate of Carpetto’s cost of common equity?

5. Cost of common equity with flotation Ballack Co.’s common stock currently sells for
$46.75 per share. The growth rate is a constant 12 percent, and the company has an expected
dividend yield of 5 percent. The expected long-run dividend payout ratio is 25 percent, and
the expected return on equity (ROE) is 16 percent. New stock can be sold to the public at the
current price, but a flotation cost of 5 percent would be incurred. What would the cost of new
equity be?