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Cost of Capital Problems


The Southwest Manufacturing Corp. (SMC) has a target capital structure of 50% debt and 50% equity. SMC is forecasting $16.2 million in retained earnings, and its last dividend was $1.00 The firm is expected to grow 10%annually indefinitely. The common stock is currently selling at $28.25 per share. Flotation costs of a new issue would be 15%. The firms before-tax cost of debt is 12%, and its marginal tax rate is 40%. An ambitious capital expenditure program is under consideration for this year. Total dollar expenditures for each project and expected rates of return are given below: Amount Project A Project B Project C Project D IRR $20 million 10 million 10 million 20 million

14.0% 12.0% 10.5% 9.2%

Assume retained earnings will be utilized before any new stock is issued. All projects, if accepted, must be taken in their entirety,i.e, you cannot accept one-half of a project. What is SMCs present cost of debt and retained earnings? (12% pre-tax and 7.2% aftertax and 13.89% for retained earnings)

What is the firms initial WACC?

(WACC 10.55%)

How much new capital can SMC raise before its marginal cost of capital increases? What isthe firms cost of new common equity and WACC when new stock is required? (Break point $32.4 m; cost of common equity 14.58%; WACC 10.89%) What is SMCs optimal capital budget for this year? What projects should be accepted?

Ross and Sons has a target capital structure that calls for 40% debt, 10% preferred and 50% equity. The firms current after-tax cost of debt is 6% and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however the firm will net only $80 per share from the sale of new preferred stock Ross expects to retain $15 million in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investor expect the dividend to grow indefinitely at a constant rate of 10% per year. Ross expects to make investments of approximately $45 million this year. What will their WACC (external) be at this level of investment? Show your work. (Kps = 12.5%, Ke = 16.47%, WACC 11.89%)


Gulf Electric Co. (GEC) uses only debt and equity in its capital structure. It can borrow unlimited amounts at an interest rate of 10% so long as it finances at its target capital structure of 55% debt and 45% common equity. Its last dividend was $2.20, its expected constant growth rate is 6%, its stock sells on the NYSE at a price of $35, and new stock would net the company $30 after flotation costs. GECs tax rate is 40%, and it expects to have $100 million of retained earnings this year. What is GECs cost of equity from newly issued stock? (13.77%) What would be their cost of capital for projects of average risk if the total capital budget were $150 million? (WACC Internal 9% ; WACC External 9.5%) Will this cost of capital go up at any point? Why and how much? ($222,222,222.22) Are there any potential drawbacks to using the firms WACC as the required rate of return for all of the projects that the firm evaluates? Explain.


AMR, parent company of American Airlines, is considering buying a fleet of new planes. Mr. Zomboni, the CFO, wants to know what the firm's cost of capital is going to be before the company makes a decision. AMR is currently capitalized with 40% debt, 50% equity, and 10% preferred stock and has no plans to change these percentages. AMR bonds ($1000 maturity value) currently sell for $949, have 16 years to maturity, and have a 12% coupon rate with interest paid semi-annually. AMR's preferred stock currently sells for $80 and has an annual dividend of $11. AMR's common stock has a current price of $85 and next year's dividend is expected to be $7. The firm's earnings and dividends are expected to grow at an annual rate of 6.5% indefinitely. The firm's marginal tax rate is 40%. What is the firm's marginal cost of capital (WACC) using internal equity? (WACC Internal 11.81%)


Tom Thumb Stores has 4,000,000 shares outstanding selling at $9 each. They have 20,000 bonds outstanding, each with a par value of $1000 and selling at 85% of par. The firm also has preferred stock outstanding with a market value of $4,000,000. What is the Tom Thumb's capital structure? AMR has been told that if they borrow from a bank instead of issuing bonds that they can borrow up to $50 million at 9%, another $40 million at 9.5% and another $10 million at 10%. At what levels of investment will they have a break points in their cost of capital based on the cost of debt increasing? ($125,000,000; $225,000,000; $250,000,000)



Heavy Metal Corp. is a steel manufacturer that finances its operations with 50 percent debt, 10 percent preferred stock and 40 percent equity. Its net income is $100 million and its dividend payout ratio is 35 percent. The companys bonds currently sell for $1,025 and their coupon rate is 11 percent with 14 years remaining to maturity. The preferred stock pays an annual dividend of $2 and sells for $20 per share. The companys common stock trades at $30 a share and its current dividend (already paid this year) of $2 a share is expected to grow at a constant rate of 8 percent per year. The flotation cost of external equity is 15 percent and the flotation cost on preferred stock is 10 percent. The bonds have minimal flotation costs of $15 each because the bonds are primarily privately placed. The company estimates that its capital budget will be in the neighborhood of $200 million. The firms marginal tax rate is 34 percent. What is the firms WACC at this level of investment? (WACC external 11.28%) What is the maximum amount that the firm could invest and still be at the firms minimum cost of capital? (BP $162,500,00) How would it affect the situation if your cost of debt were going to increase after the firm had issued $50 million in bonds?


If a moderately stable firm was using no debt at all in their capital structure and made the decision to borrow money for worthy projects so that their new capital structure was 10% debt and 90% equity, would you expect this to positively or negatively affect their stock price? Why? Currently, your firm is at its target debt ratio. You need to raise money for a very exciting new project that has massive profit potential. Why might it be in the best interest of your current stockholders to temporarily go above your target debt ratio and raise the capital with debt as opposed to selling new stock?


10. Explain what you think would happen to a companys stock price when it is able to find

projects returning more than the firms WACC? Explain in precise terms why this happens.
11. Would it be nave for a firm to use its WACC to evaluate all capital budgeting proposals?

What would be the disadvantages of that approach? How do most large corporations do this in practice?

12. Johnson Industries finances its projects with 40% debt, 10% preferred stock and 50%

common stock. The company can issue bonds at a YTM of 8.4% The cost of preferred stock is 9%. The company's common stock currently sells for $30 per share. Next years dividend is expected to be $2.12 and is expected to grow at 6%per year indefinitely. If the company issues new common stock it must pay flotation cost of $1.00 per share. Assume that the flotation cost on debt and preferred stock is zero. The company's capital budget is $600,000. The company has $200,000 in retained earnings. The company's tax rate is 30%. What is the company's WACC using internal equity (retained earnings)? 9.79%) (WACC

Can the firm complete its entire capital budgeting program at this WACC? Explain. Show your calculation?
13. The capital structure of Victorian Industries, provided below. Flotation costs would

be (a) 13% of market value for a new bond issue, (b) $1.10 per share for common stock, and (c) $1.80 per share for preferred stock. The dividends for common stock were $3.30 last year and are projected to have an annual growth rate of 5%. The firm is in a 34% tax bracket. What is the weighted cost of capital if the firm finances in the proportions shown below? Market prices are $1020 for bonds, $17 for preferred stock and $40 for common stock. There will be $325,000 of retained earnings available. Security Percent of Capital Bonds (7% coupon, 15 year maturity) 30% Preferred stock (6000 shares outstanding, $50 par, $1.45 dividend) 20% Common stock 50% Total 100% (WACC Internal 10.13%, WACC External 10.25%) Under what situations would it be appropriate to use the cost of capital determined as your required rate of return for new projects? Does a firms WACC remain constant? Why or why not?

14. Murphy Industries (a producer of hot air balloons) is considering some new projects and

wants to know what a proper required rate of return should be. You are the CFO (chief financial officer) for Murphy and the task has landed on your desk. You know that the firm recently paid a dividend on its common stock of $1.50 and that the stock is selling for $15. The earnings and dividends of the firm have been growing at approximately 7% of the selling price. The firm has bonds (semi-annual interest payments) outstanding with a coupon rate of 12%, which are currently selling for $980 and have 10 years left until maturity. Flotation costs on bonds usually run about 5% of the selling price of the bonds. The firm has preferred stock outstanding with a dividend of $14 per year, a market price of $100, with expected flotation costs on a new issue running about $8 per share. The firm is in a marginal tax bracket of 34%, has $1,500,000 in retained earnings and has the following target capital structure: Debt Preferred Stock Common Stock 50% 10% 40%

Calculate the firm's cost of debt Calculate the firm's cost of preferred Calculate the firms internal and external cost of equity Calculate the firm's WACC using internal, then external equity At what level of investment will the firm's WACC increase? Murphy is considering a wide range of investment including everything from replacement of some copiers to an investment in natural gas wells, which is an entirely new area of investment for the firm. Is this WACC appropriate for all these? What projects can we use this WACC for? Are there any other requirements for using this WACC as our required rate of return? What are the drawbacks of using WACC for projects it is not suited for. Give specific examples.