Homework Problems

After-Tax Cost of Debt

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

rd of 11%, tax rate of 0%. Round your answer to two decimal places.

rd of 11%, tax rate of 25%. Round your answer to two decimal places.

rd of 11%, tax rate of 30%. Round your answer to two decimal places.
Cost of Preferred Stock

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $56.00 a share with an annual dividend of $4.00
Ignoring flotation costs, what is the company's cost of preferred stock, rps? Round your answer to two decimal places.

Cost of Preferred Stock with Flotation Costs

Burnwood Tech plans to issue some $60 par preferred stock with a 7% dividend. A similar stock is selling on the market for $63
must pay flotation costs of 6% of the issue price. What is the cost of the preferred stock? Round your answer to two decimal p
Cost of Equity: CAPM

Booher Book Stores has a beta of 1.2. The yield on a 3-month T-bill is 3% and the yield on a 10-year T-bond is 7%. The market
is 6.5%, and the return on an average stock in the market last year was 13.5%. What is the estimated cost of common equity u
CAPM? Round your answer to two decimal places.
WACC

Shi Import-Export's balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total common
Shi's tax rate is 30%, rd = 8%, rps = 6.8%, and rs = 12%. If Shi has a target capital structure of 30% debt, 5% preferred stock, an
common stock, what is its WACC? Round your answer to two decimal places.

Bond Yield and After-Tax Cost of Debt

A company's 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 20 years sells at a price of $606.47
company's federal-plus-state tax rate is 30%. What is the firm's after-tax component cost of debt for purposes of calculating th
(Hint: Base your answer on the nominal rate.) Round your answer to two decimal places.

Cost of Equity

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 5% per year in the future. Shelby's common sto
$23.75 per share, its last dividend was $2.20, and the company will pay a dividend of $2.31 at the end of the current year.

Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.

If the firm's beta is 0.7, the risk-free rate is 4%, and the expected return on the market is 14%, then what would be the firm's c
based on the CAPM approach? Round your answer to two decimal places.

If the firm's bonds earn a return of 10%, then what would be your estimate of rs using the over-own-bond-yield-plus-judgmen
premium approach? Round your answer to two decimal places. (Hint: Use the midpoint of the risk premium range.)

On the basis of the results of parts a through c, what would be your estimate of Shelby's cost of equity? Assume Shelby values
approach equally. Round your answer to two decimal places.
The Cost of Equity and Flotation Costs

Messman Manufacturing will issue common stock to the public for $50. The expected dividend and the growth in dividends ar
share and 5%, respectively. If the flotation cost is 10% of the issue's gross proceeds, what is the cost of external equity, re? Ro
answer to two decimal places.

WACC Estimation

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise a
$20 million in new projects. The firm's present market value capital structure, here below, is considered to be optimal. There i
term debt.

Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 10% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The st
required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%
expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 30%.

In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Ent
answer in dollars. For example, $1.2 million should be entered as $1200000.

Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of
what is its WACC? Round your answer to two decimal places.

Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, w
happen to the WACC? No numbers are required to answer this question.
I. rs will increase and the WACC will decrease due to the flotation costs of new equity.
II. rs will decrease and the WACC will increase due to the flotation costs of new equity.
III. rs and the WACC will not be affected by flotation costs of new equity.
IV. rs and the WACC will increase due to the flotation costs of new equity.
V. rs and the WACC will decrease due to the flotation costs of new equity.
Homework Solutions

aftertax cst of debt = rd (1-T)

aftertax cst of debt = .11 (1-0) = .11
aftertax cst of debt = .11(1-.25) = .0825
aftertax cst of debt = .11 (1-.30) = .077

rps = Dps/Pps (1-F)

rpx = 4.00/56 = .0714286
Preferred dividend = $60 x .07 = 4.2
rps = Dps/Pps (1-F)
rps = 4.2/63(1-.06) = .07092199

rs = yield on bond + beta (RPm)

rs = .07 + 1.2 (.065) = .148
WACC = Wdrd(1-T) + Wps(rpx) + Ws(rs)
WACC = .30x.08(1-.3) + .05(.068) + .65(.12)
WACC = .0168 + .0034 + .078 = .0982

PV = $606.47
FV = $1000
n = 20x2 = 40
I/Yr = ? --> 5.43% --> times 2 = 10.8599%
PMT = (.06x1000)/2 = 30
After tax cost of debt = rd = 10.8599%(1-30%) = .
07601930

rs = D1/P0 + expected gL
rs = 2.31/23.75 + .05 = .14726316

rs = rRF + beta (RPm) = .04+0.7(.14-.04) = .11

rs = .10 + .04 = .14

Best estimate = average = .14726316 + .11 + .14 / 3

Best estimate = .1324333
re = D0(1+g)/P0(1-F) + g
re = 3.75/50(1-.10) + .05
re = 3.75/45 +.05
re = .1333333
Related Book Problem
Calculate the after-tax cost of debt under each of the following conditions:

rd of 13%, tax rate of 0%

rd of 13%, tax rate of 20%

rd of 13%, tax rate of 35%

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a share with an annual dividend of $4.5
a share. Ignoring flotation costs, what is the company’s cost of preferred stock, rps ?

Burnwood Tech plans to issue some $60 par preferred stock with a 6% dividend. A similar stock is selling on the market
for $70. Burnwood must pay flotation costs of 5% of the issue price. What is the cost of the preferred stock?

Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4%, and the yield on a 10-year T-bond is 6%. The
market risk premium is 5.5%, and the return on an average stock in the market last year was 15%. What is the estimated
cost of common equity using the CAPM?
Shi Import-Export’s balance sheet shows $300 million in debt, $50 million in preferred stock, and $250 million in total
common equity. Shi’s tax rate is 40%, rd=6%, rps=5.8% and rs=12% . If Shi has a target capital structure of 30% debt, 5%
preferred stock, and 65% common stock, what is its WACC?

A company’s 6% coupon rate, semiannual payment, $1,000 par value bond that matures in 30 years sells at a price of $515.16
The company’s federal-plus-state tax rate is 40%. What is the firm’s after-tax component cost of debt for purposes of
calculating the WACC? (Hint: Base your answer on the nominal rate.)

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby’s
common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the en
of the current year.
Using the discounted cash flow approach, what is its cost of equity?

If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is 13%, then what would be the
firm’s cost of equity based on the CAPM approach?

If the firm’s bonds earn a return of 12%, then what would be your estimate of rs using the own-bond-yield-plus-
judgmental-risk-premium approach? (Hint: Use the mid-point of the risk premium range.)

On the basis of the results of Parts a through c, what would be your estimate of Shelby’s cost of equity?
Messman Manufacturing will issue common stock to the public for $30. The expected dividend and the growth in dividends ar
$3.00 per share and 5%, respectively. If the flotation cost is 10% of the issue’s gross proceeds, what is the cost of external
equity, re ?

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 here, is considered to be
optimal. There is no short-term debt.

Tysseland Company’s present market value capital structure is shown in the table with two columns. Rows 1 to 3 reads: Debt,
dollars 30,000,000; Common equity, 30,000,000; Total capital, dollars 60,000,000.
Debt $30,000,000
Common Equity $30,000,000
Total Capital $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The
stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant
growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is 1.20/30 = 4% .) The marginal tax rate is 40%.

In order to maintain the present capital structure, how much of the new investment must be financed by common equity?

Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of
equity, what is its WACC?

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? No numbers are required to answer this question.
Book Solution

aftertax cst of debt = rd (1-T)

aftertax cst of debt = .13 (1-0) = .13
aftertax cst of debt = .13(1-.2) = .104
aftertax cst of debt = .13 (1-.35) = .0845 0.07700

rps = Dps/Pps (1-F)

rpx = 4.50/50 = .090 0.0714286

Preferred dividend = $60 x .06 = 3.6

rps = Dps/Pps (1-F)
rps = 3.6/70(1-.05) = .054135 0.07092199 66.5000000000000000
rs = yield on bond + beta (RPm)
rs = .06 + 0.8 (.055) = .104

0.078000 0.148000
WACC = Wdrd(1-T) + Wps(rpx) + Ws(rs)
WACC = .30x.06(1-.4) + .05(.058) + .65(.12)
WACC = .0108 + .0029 + .078 = .0917 0.056000 0.0168

PV = $515.16
FV = $1000
n = 30x2 = 60
I/Yr = ? --> 6% --> times 2 = 12%
PMT = (.06x1000)/2 = 30
After tax cost of debt = rd = 12%(1-40%) = .0720
0.07601930

rs = D1/P0 + expected gL
rs = 2.14/23 + .07 = .16304348

rs = rRF + beta (RPm) = .09+1.6(.13-.09) = .154

rs = .12 + .04 = .16

Best estimate = average = .16 + .154 + .163 / 3

Best estimate = .159 0.09726316 0.14726316
re = D0(1+g)/P0(1-F) + g
re = 3/30(1-.10) + .05
re = 3/27 +.05
re = .161111

3.75000 45

refer to tab 0.054187192118227 0.081459919318227

4.2000000
 0.003400 0.07800 0.09820

0.2409046250 0.4424778750 0.75940180 0.00759401800 0.07759401800

0.13243333333
0.08333 0.1333333333
Debt
30,000,000 Next Expected Div 1.20
Common Equity P0 30.00
30,000,000 Growth 0.08
Total Capital Coupon rate 0.10
60,000,000

Weight of Equity Equity/Total Capital

Weight of Equity 0.500000000000
Investment Financed by CE 10000000

WACC 0.0950000000
Weight of Equity 0.50
re 0.12
Weight of Debt 0.5
After tax cost of debt 0.07

If there is now not enough internal cash flow and the firm must issue new shares of stock then rs and the WACC wil increase d
 Investment
20,000,000.00

s and the WACC wil increase due to the flotation costs of new equity.