Practice Problem Set #12: Cost of Capital

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. Is cost of capital of a firm determined by the source of the funds or the use of funds? Explain.
2. What are the advantages and disadvantages of using CAPM to calculate cost of equity.
3. The Gordon Growth Model can be used to estimate cost of equity. Why is this method not ideal?
4. Explain how you would calculate beta of a stock.
5. Can a firm’s beta change over time? How would you adjust your calculation of beta to reflect a
change of business?
6. Why is the coupon rate of a bond not used for calculating cost of debt?
7. Why do we prefer to use market value weights of debt and equity when calculating WACC?
8. A firm has preferred shares and multiple bond issues. How do you adjust your WACC calculation?
9. When is it appropriate to use WACC as the discount rate when determining the NPV of a project?
10. What is a consequence of using WACC as the discount rate for all projects of a firm?

Practice Problems:
1. Suppose a company has five-year, $1,000 face value, semi-annual-coupon bonds with
an 8% coupon rate and a YTM of 3.594%. What would be the market value of one of
these bonds? What would be the required return by the bondholders?

2. A share of preferred stock that pays an annual dividend of $7 per share is selling for $87.
What is the required rate of return by preferred shareholders?

3. Alma Company’s zero coupon bonds mature in 20 years and have a YTM of 12.01%.
Each zero has a face value of $1,000 and there are 2,000 of the bonds outstanding. If
the market value of Alma’s equity is $1,000,000, what capital structure weight for debt
would you use in calculating the WACC, assuming Alma’s only debt consists of the zero
coupon bonds?

4. Given the following information, what is Wexford Corporation’s WACC?

Common Stock: 1 million shares outstanding, $40 per share market price, Beta = 1.3
Bonds: 10,000 bonds outstanding, $1,000 face value each, 8% annual coupon, 22 years
to maturity, YTM = 7.079%
Market risk premium = 8.6%, risk-free rate = 4.5%

5. Suppose that Harris Limited has 19 million shares of common stock outstanding. The
current market price per share is $18.35. Harris has outstanding debt with a par (or face)
value of $114.5 million selling at 96% of its par value. What capital structure weight would
you use for debt when calculating the WACC of Harris Limited?
6. Given the following information, what is Angus Corporation’s WACC?
Common Stock: 6.5 million shares outstanding, $15 per share market price, Beta = 1.25
Preferred Stock: 2 million shares outstanding, $8 per share market price, $10 per share
par value, annual preferred dividend rate = 6%
Bonds: 25,000 bonds outstanding, $1,000 face value each, semi-annual coupons, 5%
coupon rate, 10 years to maturity, YTM = 5.8%
Expected return on market = 10%, risk-free rate = 3%