Cost of Capital

COST OF CAPITAL: TUTORIAL QUESTIONS

Question 1

a. Why do we use overall cost of capital for investment decisions even when only one
source of capital will be used (ex:debt).
- Explain the concept of coc.
- Though an investment financed by low-cost debt might appear acceptable at first
glance, the use of debt could increase the overall risk of the firm and eventually make all
forms of financing more expensive. Each project must be measured against the overall
cost of funds to the firm.

b. What are the two sources of equity (ownership) capital for the firm?

- Answers to include the os and ps. Also explanation on retained earnings.

c. How are the weights determined to arrive at the optimal weighted average cost of
capital?

- They are determined by examining different capital structures and using that mix which
gives the minimum cost of capital.

Companies must solve a multidimensional problem to determine the proper weights

which includes determining the optimal cost of debt and cos of equity.

d. A company chooses to use different type of debt for the company’s business
operations. Is it possible to use WACC to evaluate the company? Explain
- Yes. The WACC multiplies the percentage costs of debt—after accounting for the
corporate tax rate—and equity under each proposed financing plan by a weight
equal to the proportion of total capital represented by each capital type. This allows
businesses to determine which levels of debt and equity financing are most cost-
effective.

Ms Shazlina AJ 1
Cost of Capital

Question 2

Assume the following capital structure for the Morgan Corp:

Debt: 35%
Preferred Stock: 15%
Common Equity: 50%

The following facts are also provided:

Bond yield to maturity: 9%

Corporate tax rate: 25%
Dividend, preferred stock: RM8.50
Price, Preferred Stock: RM100.00
Flotation cost, preferred stock: RM2.00
Dividend, common stock: RM1.20
Price: Common Stock: RM30.00
Growth Rate, common stock: 9%

Compute the weighted average cost of capital

Cost of Debt
= 9% (1-25%)
= 6.75%

Cost of Preferred Stock = D/Po-F

= 1.20/100-2
= 1.22%

Cost of Common Stock = D/P + g

= 1.2/30 + 9%
= 13%

WACC = Cost of Debt + Cost of Preferred Stock + Cost of Common Stock

= 0.35(6.75%) + 0.15(1.22%) + 0.5(13%)
= 9.05%

Ms Shazlina AJ 2
Cost of Capital

Question 3

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

Yield Corporate tax rate

8.0% 18%
12.0 34
10.6 15

Cost of Debt = Interest Expense (1 - Tax Rate)

i. 8% (1-18%)
6.56%
ii. 12.0%(1- 34%)
7.92%
iii. 10.6%(1-15%)
9.01%

Question 4

Global Technology’s capital structure is as follows:

Debt: 35%
Preferred Stock: 15%
Common Equity: 50%

The aftertax cost of debt is 6.5%; the cost of preferred stock is 10%; and the cost of common
equity is 13.5%. Calculate the firms weighted average cost of capital.

0.35(6.5%) + 0.15(10%) + 0.5(13.5%) = 0.02275 + 0.015 + 0.0675 = 10.525%

Ms Shazlina AJ 3
Cost of Capital

Question 5

Eva Tech has the following capital structure

Debt: 40%
Common Equity: 60%

The after-tax cost of debt is 6% and the cost of common equity is 13%.

a. What is the firms weighted average cost of capital?

b. An outside consultant has suggested that because debt is cheaper than equity, the firm
should switch to a capital structure that is 50% debt and 50% equity. Under this newer
and more debt-oriented arrangement, the after-tax cost of debt is 7% and the cost of
common equity is 15%. Recalculate the firms Weighted Average Cost of Capital.
c. Which plan is optimal in terms of minimizing the weighted average cost of capital.

a. WACC = wkd (cost of debt after tax)+ ws(cost of stock)+wp(cost of ps)

= 0.4(0.06)+0.6(0.13)
= 10.2%
b. WACC = wkd (cost of debt after tax)+ ws(cost of stock)+wp(cost of ps)
= 0.5(0.07)+0.5(0.15)
= 11%
c. The optimal plan to choose will be Plan A. Plan A has a lower WACC rate. A
high weighted average cost of capital, or WACC, is typically a signal of the higher
risk associated with a firm's operations.

Ms Shazlina AJ 4