9-3 How would each of the following affect a firm’s cost of debt, rd(1-t); its cost of equity, rs;

and

its weighted average cost of capital, WACC? Indicate by a plus (+), a minus (-), or a zero (0) if

the factor would rise, lower, or have an indeterminate effect on the item in question. Assume

other things are held constant. Be prepared to justify your answer, but recognize that several of

the parts probably have no single correct answer; these questions are designed to stimulate

thought and discussion.

Effect on

Rd (1 – T) rs WACC
a.       The corporate tax rate is lowered (+) (0) (+)
b.      The federal Reserve tightens credit (+) (+) (+)

c.       The firm uses more debt (+) (+) (+)

d.      The firm doubles the amount of capital it raises during the (+ or 0) (+or 0) (+ or 0)
year.
e.       The firm expands into a risky new area (+) (+) (+)

f.        Investors become more risk averse (+) (+) (+)

a.       When corporate tax rate is lowered cost of debt after tax increase while cost of equity does not

have any effect and WACC will increase as cost of debt increase.

b.      When federal reserve tightens credit, cost of debt increase as in the economy few funds are

available hence increase interest rate as well as cost of debt, equity, and WACC.

c.       When the firm uses more debt, firm’s capital structure consists of more debt and hence seems

more risky. It increases cost of debt, equity, WACC.

d.      When the firm doubles the amount of capital raise within a year cost of debt, cost of equity and

WACC may increase or remain the same depending on purpose of raising the fund. In most of
 the case when company doubles its capital WACC, cost of debt and cost of equity tend to

increase.

e.       When firm expands its business into risky area its cost of capital, cost of equity and WACC

increase because of the variability in return.

f.        When investors become more risk averse cost of debt, cost of equity and WACC increase as it

increases the interest rates.

1. Calculate the after-tax cost of debt under each of the following conditions:
a) Interest rate, 13% ; tax rate, 0%
b) Interest rate, 13% ; tax rate, 20%
c) Interest rate, 13% ; tax rate, 34%
Solution
a) Given, Interest rate (Kd) = 13%; Tax rate (t) = 0%
After tax cost of debt (Kdt) = Kd(1-t) = 13% ( 1- .0) = 13%
b) Given, Interest rate (Kd) = 13%; Tax rate (t) = 20%
After tax cost of debt (Kdt) = Kd(1-t) = 13% ( 1- .20) = 10.40%
c) Given, Interest rate (Kd) = 13%; Tax rate (t) = 34%
After tax cost of debt (Kdt) = Kd(1-t) = 13% ( 1- .34) = 8.58%

LL's "marginal" debt rate (rd = rate debt) = 8% (it believes it can issue new debt at par at this rate)

After Tax cost of debt = rd * (1- tx rate)

0.08 * (1 - 0.35)

= 0.08 * (0.65)

= 0.052 or 5.2%

LL Incorporated's currently outstanding 11% coupon bonds have a yield to maturity of

8%. LL believes it could issue new bonds at par that would provide a similar yield to
maturity. If its marginal tax rate is 35%, what is LL's after-tax cost of debt?
LL's "marginal" debt rate (rd = rate debt) = 8% (it believes it can issue new debt at par at
this rate)
After Tax cost of debt = rd * (1- tx rate)
0.08 * (1 - 0.35)
= 0.08 * (0.65)
= 0.052 or 5.2%

Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a
share. The issue is expected to pay a constant annual dividend of $4.50 a
share.Ignoring flotation costs, what is the company's cost of preferred stock, rps?
cost of preferred stock = dividend on preferred stock/price of preferred stock

4.5 /50=9%

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?
Par Value of Preferred Stock = $60Dividend percentage = 6%Market Value of the stock
= $70Flotation costs = 5% of the issue priceCost of Preferred Stock =?

Annual Dividend Payment on Preferred Stock = [6% * $60]Annual Dividend Payment on

Preferred Stock = $3.60

Cost of Preferred Stock = [Preferred Stock dividend / Market Price ofPreferred Stock]
[OR]Cost of Preferred Stock = [Preferred Stock dividend / Market Price ofPreferred
Stock (1-Flotation cost)]

Cost of Preferred Stock = [($60 * 6%) / $70 (1-0.05)]

Cost of Preferred Stock = [$3.60 / $70 (0.95)]
Cost of Preferred Stock = [$3.60 / $66.50]
Cost of Preferred Stock = 0.054135Cost

of Preferred Stock = 5.41%

summerdahl Resort's common stock is currently trading at $36 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% a year. What is its cost of
common equity?
P= D1/(r-g)
Here we have3.00/(r-.05) = 36
r-.05= 3/36= 0.08333r= 0.1333= 13.33%

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?
rs = Rrf + (b x Rpm)
rs = 0.06 + (0.8 x 0.055) =
rs = 0.06 + 0.044
rs = 0.104

The cost of common equity is 10.4%

Shi Importer'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?
(30% .6%)(1 - 40%) + (5% 5.8%) + (65% 12%) = 0.0917

9.17% WACC

WACC=Respective costs*Respective weights

David Ortiz Motors has a target capital structure of 40% debtand 60% equity. The yield
to maturity on the company'soutstanding bonds is 9% and the company's tax rate if
40%. Ortiz's CFO has calculated the company's WACC as 9.96%. Whatis the
company's cost of equity capital?
WACC = (percentage debt)YTM(1 - Corporate tax rate) + (percentageequity)*(Cost of
equity)

9.96 = 0.49(1-0.4) + 0.6*(Cost of Equity)

9.96 = 2.16 + 0.6*(Cost of Equity)

13% = Cost of Equity

Answer:
After-tax cost of debt is 7.2%
Explanation:
Given:
Coupon rate = 6% or 0.06 per annum.
Semi- annual coupon rate = 0.06÷2 = 0.03
Par value is 1,000
Coupon payment = 0.03×1000 = $30
Time period = 30×2= 60 semi-annual periods
Bond price = $515.16
Pre-tax cost of debt can be computed using excel function 'RATE'
=RATE(nper,PMT,PV,FV)
nper is 60; PMT is 30; PV is -515.16 (cash outflow); FV is 1000
Rate is 6%
Calculation is shown in attached excel snip.
Yield to maturity =
Federal tax rate is 40% or 0.4
After-tax cost of debt = 0.12 (1-0.4)
                                  = 0.072 or 7.2%  

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 end of the current year.
(a) Using the discounted cash flow approach what is the cost of equity?
Stock price = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
a)
$23 = $2.14÷(r-7%)
Cost of equity, r = 16.3%

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 end of the current year.
b) If the firms 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?
Expected return = Rf+β×Rp
Rf is risk free return
Rp is risk premium
= 9%+1.6×(13%-9%)
= 15.4%

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 end of the current year.
(c) if the firm's bonds earn a return of 12% then what would be your estimate of rs using
the own bond yield plus judgement risk premium approach?
Cost of equity:
= Bond yield+Market risk premium
= 12%+(13%-9%)
= 16%

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 end of the current year.
(d) on the basis of the results of parts a through c what would be your estimate of
Shelbys cost of equity?
Estimate of the shelbys cost of equity:
= (16.3%+15.4%+16%)÷3
= 15.9%

Radon Homes current EPS is $6.50. It was $4.42 five years ago. The company pays out
40% of its earnings as dividends and the stock sells for $36.

(a) Calculate the historical growth rate in earnings (hint this is a 5-year growth period.)
N= 5
PV= -4.42
PMT= 0
FV= 6.5
Calc. I
= 8%

Radon Homes current EPS is $6.50. It was $4.42 five years ago. The company pays out
40% of its earnings as dividends and the stock sells for $36.

(b) Calculate the next expected dividend per share D1. (Hint Do = 0.4 ($6.50) = $2.60.)
Assume that the past growth rate will continue.
Next expected dividend:
= $6.50×0.40×(1+8%)
= $2.81

= Current EPS x (1+ growth rate)x payout ratio

Radon Homes current EPS is $6.50. It was $4.42 five years ago. The company pays out
40% of its earnings as dividends and the stock sells for $36.

(c) What is Radon's cost of equity, rs?

Stock price = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
$36 = $2.81÷(r-8%)
Cost of equity, r = 15.81%

Spencer Supplies' 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. If investors require a
9% return, what rate of growth must be expected for Spencer?
As per CAPM
Growth = Required Return - Dividend per share / Price per share
Growth = 9% - 3.60 / 60
Growth = 9% - 6%
Growth = 3%

Spencer Supplies' 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
-If Spencer reinvests earnings in projects with average returns equal to the stock's
expected rate of return, what will be next year's EPS?
Next year EPS = Current EPS X (1 + Growth)
Next year EPS = 5.40 X (1 + 3%)
Next year EPS = 5.562

Messman Manufacturing will issue common stock to the public for $30. The expected
dividend and the growth in dividends are $3.00 per share and 5%, respectively. If th
flotation cost is 10% of the issue's gross proceeds, what is the cost of the external
equity?
Cost of external equity= [Dividend/price x (1 - flotation cost) ]+ Growth

[3/ 30x(1-10%)] + 5%

= 16.11%

Suppose a company will issue new 20-year debt with a par value of $1,000 and a
coupon rate of 9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the
issue proceeds, then what is the after-tax cost of debt? Disregard the tax shield from the
amortization of flotation costs.
- What if flotation costs were 10% of bonds issued?
rd = C/NP x( 1-t)

[9%x$1,000/(1-2%)x 1,000] x (1-.4)

=5.5%

 The debt year is n=20n=20

 Coupon rate is E=9%=0.09E=9%=0.09

 The tax rate is R=40%=0.4R=40%=0.4

 The flotation cost is FC=2%=0.02FC=2%=0.02

 Par value is  d=$1000 d=$1000

The expression for the cost of debt is

rd=CNP(1−R)rd=CNP(1−R)
Where C is the coupon, NP is the net proceeds
rd=CNP(1−R)×100=E×d(1−FC)×d×(1−R)×100=9%× $1000(1−0.02)×$1000×(1
−0.40)×100=900.98×1000×(0.6)×100=90980×60=5.57%rd=CNP(1−R)×100=E
×d(1−FC)×d×(1−R)×100=9%× $1000(1−0.02)×$1000×(1−0.40)×100=900.98×
1000×(0.6)×100=90980×60=5.57%
Thus the cost of debt is rd=5.57%

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. 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% 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%.a.

In order to maintain the present capital structure, how much of the new investment must
be financed by common equity?
Required Investments = $30,000,000

Since the total market value of the firm is $60,000,000

Out of that, $30,000,000 is financed through equity, then the weight of equity
= $30,000,000 / $60,000,000= 0.5

Common equity needed = Total Amount of Investment × Weight of Equity

= 0.5($30,000,000)= $15,000,000.

Assuming there is sufficient cash flow for Tysseland to maintain its target capital
structure without issuing additional shares of equity, what is its WACC?
Cost of Equity =D/P+g
1.20/30+0.08= %12

After Tax Cost of Debt = Before Tax Cost of Debt × (1-Tax Rate)
8 × (1-0.4)= 4.8%

WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × After Tax Cost of Debt)

(0.5 × 12%) + (0.5 × 4.8%)= 8.4%