Benzon A.

Ondovilla BSA-3203
18-52259
Indicate by a plus (+), a minus (−), or a zero (0) if the factor would raise, lower, or have
an indeterminate effect on the item in question. Assume that all other factors 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 (+ or 0) (+or 0) (+ or 0)

raises during the 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 riskier. 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.
(9-1) After-Tax Cost of Debt
After-tax component cost of debt=Interest Rate−Tax savings
= rd−rdT
= rd (1 −T)
Calculate the after-tax cost of debt under each of the following conditions:
a. Interest rate of 13%, tax rate of 0%
After-tax component cost of debt = rd (1 −T)
= 13% (1-0)
= 13% (1)
= 13%
b. Interest rate of 13%, tax rate of 20%
After-tax component cost of debt = rd (1 −T)
= 13% (1-0.20)
= 13% (0.80)
= 10.40%
c. Interest rate of 13%, tax rate of 35%
After-tax component cost of debt = rd (1 −T)
= 13% (1-0.35)
= 13% (0.65)
= 8.45%

(9–2) After-Tax Cost of Debt

After-tax component cost of debt=Interest Rate−Tax savings
= rd−rdT
= rd (1 −T)
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? 5.20%
After-tax component cost of debt = rd (1 −T)
 = 8% (1-0.35)
= 8% (0.65)
= 5.20%

(9–3) Cost of Preferred Stock

D ps
Cost of Preferred stock=r ps = Dps = preferred dividend
P ps (1−F)

Pps =preferred stock price

F = flotation cost
Duggins Veterinary Supplies can issue perpetual preferred stock at a price of $50 a
share with an annual dividend of $4.50 a share. Ignoring flotation costs, what is the
company’s cost of preferred stock, rps? 0.09 or 9%
D ps
r ps =
P ps (1−F)
$ 4.50
r ps =
$ 50(1−0)
$ 4.50
r ps =
$ 50(1)
$ 4.50
r ps =
$ 50
r ps =0.09∨9 %

(9–4) Cost of Preferred Stock with Flotation Costs

D ps
Cost of Preferred stock=r ps = Dps = preferred dividend
P ps (1−F)

Pps =preferred stock price

F = flotation cost
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? 0.0541 or 5.41%
 D ps
r ps =
P ps (1−F)

($ 60∗0.06)
r ps =
$ 70(1−0.05)
$ 3.60
r ps =
$ 70(0.95)
$ 3.60
r ps =
$ 66.50
r ps =0.0541∨5.41 %

(9–5) Cost of Equity: DCF

D1
P 0=
r s−g

P0= price of the stock

D1= dividend expected to be paid at the end of Year 1
rs= required rate of return
g= expected growth rate in dividends
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 (D 1= $3.00), and the
dividend is expected to grow at a constant rate of 5% a year. What is its cost of
common equity? 0.1333 or 13.33%
D1
P 0=
r s−g
$3
$ 36=
r s−0.05

$3
r s−0.05=
$ 36
r s−0.05=0.0833

r s=0.0833+0.05

r s=0.1333∨13.33 %
(9–6) Cost of Equity: CAPM
r s=r RF + ( RP M ) b i

rs= required rate of return

rRF= the risk-free rate,
RPm= risk premium on the market
bi= beta coefficient
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? 0.104 or 10.40%
r s=r RF + ( RP M ) b i

r s=0.06+ ( 0.055 ) 0.8

r s=0.06+0.044

r s=0.104∨10.40 %

(9–7) WACC
WACC=wd r d ( 1−T )+ w ps r ps+ w s r s

wd= target weights for debt

rd= cost of debt
T= tax rate
wps= target weights preferred stock
rps= cost of preferred stock
ws= target weights common equity
rs= cost of common equity
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%, r d= 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? 0.0917 or 9.17%
WACC=wd r d ( 1−T )+ w ps r ps+ w s r s

WACC=(0.30∗0.06) (1−0.40 ) +( 0.05∗0.058)+(0.65∗0.12)

WACC=(0.018) ( 0.60 ) +(0.0029)+( 0.078)
WACC= ( 0.0108 ) + ( 0.0029 ) + ( 0.078 )
WACC=0.0917∨9.17 %

(9–8) WACC
WACC=wd r d ( 1−T )+ w ps r ps+ w s r s

wd= target weights for debt

rd= cost of debt
T= tax rate
wps= target weights preferred stock
rps= cost of preferred stock
ws= target weights common equity
rs= cost of common equity
David Ortiz Motors has a target capital structure of 40% debt and 60% equity. The yield
to maturity on the company’s outstanding bonds is 9%, and the company’s tax rate is
40%. Ortiz’s CFO has calculated the company’s WACC as 9.96%. What is the
company’s cost of equity capital? 0.13 or 13%
WACC=wd r d ( 1−T )+ w ps r ps+ w s r s

0.0996=0.09 ( 1−0.40 ) ( 0.40 ) +(0)+(0.60) r s

0.0996=(0.09)(0.60)(0.40)+(0)+(0.60) r s

0.0996=(0.054 )(0.40)+(0)+(0.60) r s

0.0996=(0.0216)+(0)+(0.60) r s

( 0.60 ) r s =0.0996−0.0216

( 0.60 ) r s 0.078
=
0.60 0.60
r s=0.13∨13 %
INTERMEDIATE PROBLEMS 9–14

(9–9) Bond Yield and After-tax Cost of Debt

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.) 7.20%

Coupon rate = 6%
Semi-annual coupon rate = 0.06÷2 = 0.03
Par value = 1,000
Coupon payment = 0.03×$1000 = $30
Time period = 30×2= 60
Bond price = $515.16
= RATE(60,30,-515.16,1000)
RATE= 6%
Yield to maturity = 6×2 = 12%
Tax rate= 40%

After-tax component cost of debt = rd (1 −T)

= 12% (1-0.40)
= 12% (0.60)
= 7.20%

(9–10) Cost of Equity

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 its cost of equity? 0.163 or 16.30%
D1
P 0=
r s−g

P0= price of the stock

D1= dividend expected to be paid at the end of Year 1
rs= required rate of return
g= expected growth rate in dividends
$ 2.14
$ 23=
r s−0.07

$ 2.14
r s−0.07=
$ 23
r s−0.07=0.0930

r s=0.0930+0.07

r s=0.163∨16.30 %

b. 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?
0.154or 15.40%
r s=r RF + ( RP M ) b i

rs= required rate of return

rRF= the risk-free rate,
RPm= risk premium on the market
bi= beta coefficient
r s=0.09+ ( 0.13−0.09 ) 1.6

r s=0.09+ ( 0.04 ) 1.6

r s=0.09+0.064

r s=0.154∨15.40 %

c. If the firm’s bonds earn a return of 12%, then what would be your estimate of r s using
the over-own-bond-yield-plus-judgmental-risk-premium approach? (Hint: Use the
midpoint of the risk premium range.) 0.16 or 16%
r s=By+ ( RP M )

rs= required rate of return

By= Bond yield
RPm= risk premium on the market
r s=0.12+(0.13−0.09)
r s=0. 12+ 0.04

r s=0. 16∨16 %

d. On the basis of the results of parts a through c, what would be your estimate of
Shelby’s cost of equity? 0.159 or 15.90%
(r s 1 +r s2 +r s 3 )
Estimate of the Shelb y' s cost of equity =
3
rs1= cost of equity using the discounted cash flow approach
rs2= cost of equity based on the CAPM approach
rs3= estimate of rs using the over-own-bond-yield-plus-judgmental-risk-premium
approach
(0.163+0.154+ 0.16)
Estimate of the Shelb y' s cost of equity =
3
0.477
Estimate of the Shelb y' s cost of equity =
3

Estimate of the Shelb y' s cost of equity =0.159∨15.90 %

(9–11) Cost of Equity

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.)
0.0802 or 8.02%

P P 1n
Growth rate= ( ) CP
−1

PP= Price Five years back

CP= Current Price
n= number of years

$ 6.50 15
Growth rate= ( $ 4.42) −1

Growth rate=( 1.4706 )0.20−1

Growth rate=1.0802−1
Growth rate=0.0802∨8.02 %
b. Calculate the next expected dividend per share, D 1. (Hint: D0= 0.4($6.50) = $2.60.)
Assume that the past growth rate will continue. $2.8085 or $2.81
D1=D0*(1+g)
D1= expected dividend per share
D0= current dividend per share
g= growth rate
D1= $2.60*(1+0.0802)
D1= $2.60*(1.0802)
D1= $2.8085 or $2.81
c. What is Radon Homes’ cost of equity, rs? 0.1583 or 15.83%
D1
( )
r s=
P0
+g

rs= cost of equity

D1= expected dividend per share
P0= current price of common stock

( $$2.81
r s=
36 )
+0.0802

r s=0.0781+0.0802

r s=0.1583∨15.83 %

(9–12) Calculation of g and EPS

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.
a. If investors require a 9% return, what rate of growth must be expected for Spencer?
0.03 or 3%
Ds
Growth Rate=r s − ( )
Ps

rs= Required Return

Ds= Dividend per share
Ps= Price per share
Growth Rate=0.09− ( $$3.60
60 )
Growth Rate=0.09−0.06
Growth Rate=0.03∨3 %
b. If Spencer reinvests earnings in projects with average returns equal to the stock’s
expected rate of return, then what will be next year’s EPS? (Hint: g = ROE × Retention
ratio.) $5.562 or $5.56
EPS 1=EPS0∗(1+ g)

EPS1= next year’s EPS

EPS0= Current EPS
g= Growth rate
EPS 1=$ 5.40∗(1+0.03)

EPS 1=$ 5.40∗( 1.03 )

EPS 1=$ 5.562∨$ 5.56

(9–13) The Cost of Equity and Flotation Costs

De
Cost of external equity=r e = +g
Pe (1−F)

De= common stock dividend

Pe= common stock price
F = flotation cost
g= expected growth rate in dividends
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 the
flotation cost is 10% of the issue’s gross proceeds, what is the cost of external equity,
re? 0.1611 or 16.11%
De
re= +g
Pe (1−F)
$3
re= +0.05
$ 30(1−0.10)
 $3
re= + 0.05
$ 30(0.90)
$3
re= + 0.05
$ 27
r e =0.1111+ 0.05

r e =0.1611∨16.11 %

(9–14) The Cost of Debt and Flotation Costs

rd = ( NPC )(1−T )
rd= after-tax cost of debt
C= coupon
NP= net proceeds
T= tax rate
Suppose a company will issue new 20-year debt with a par value of $1,000 and a
coupon rate of 9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the
issue proceeds, then what is the after-tax cost of debt? Disregard the tax shield from the
amortization of flotation costs. 0.0551 or 5.51%
0.09∗$ 1,000
rd =
( ( 1−0.02 )∗$ 1,000 )
(1−0.40)

90
r =
d
( ( 0.98 )∗$ 1,000 )(0.60)
90
rd = ( 980 )(0.60)
r d =( 0.0918 ) ( 0.60 )

r d =0.0551∨5.51 %
Summary of answer
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 (+ or 0) (+or 0) (+ or 0)

raises during the 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 riskier. 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.

(9-1)
a. 13%
 b. 10.40%
c. 8.45%
(9-2) 5.20%
(9-3) 0.09 or 9%
(9-4) 0.0541 or 5.41%
(9-5) 0.1333 or 13.33%
(9-6) 0.104 or 10.40%
(9-7) 0.0917 or 9.17%
(9-8) 0.13 or 13%
(9-9) 7.20%
(9-10)
a. 0.163 or 16.30%
b. 0.154 or 15.40%
c. 0.16 or 16%
d. 0.159 or 15.90%
(9-11)
a. 0.0802 or 8.02%
b. $2.8085 or $2.81
c. 0.1583 or 15.83%
(9-12)
a. 0.03 or 3%
b. $5.562 or $5.56
(9-13) 0.1611 or 16.11%
(9-14) 0.0551 or 5.51%