Define the following terms:

WACC and choosing Weights

WACC (Weighted Average Cost of Capital) is a financial metric that calculates the average cost of all the capital that a company

has raised, including equity and debt. It is used to determine the minimum return that a company must earn on its existing assets to

satisfy its creditors, owners, and other stakeholders.

Choosing weights in WACC calculation involves determining the proportion of each source of capital in the company's capital

structure. The weight of each source of capital is determined by dividing the market value of that source by the total market value of

all sources of capital. The weights are then used to calculate the average cost of capital, which is the weighted average of the cost of

each source of capital.

The cost of Debt

The cost of debt refers to the interest rate a company pays on its outstanding debt, such as bonds or loans. It is the cost a company

incurs for borrowing money and is an important factor in evaluating a company's financial health and ability to pay its debts. The

cost of debt is a key component in calculating a company's weighted average cost of capital (WACC), which is used to determine

the minimum return a company must earn on its investments to meet the expectations of its shareholders and creditors.

The cost of Preferred Stock

The cost of preferred stock refers to the price at which it is sold to investors and can vary depending on a number of factors such as

the issuing company's financial health, dividend payment history, and overall market conditions. It is typically higher than the cost

of common stock but provides a higher priority claim on a company's assets and earnings. The cost of preferred stock is also

influenced by interest rates, as investors may choose to buy preferred stock when interest rates are low.

The cost of internal equity

The cost of internal equity refers to the opportunity cost of using internal funds (e.g. retained earnings) to finance a company's

operations and investments, instead of obtaining external financing (e.g. issuing bonds). It represents the return that shareholders

could have received if the internal funds were used for alternative investments.

It is not represented by a symbol, but rather by a theoretical calculation or estimate of the foregone return.
The coat of external equity

The cost of external equity refers to the price that a company must pay to raise funds from external sources such as the public or

institutional investors. This cost includes the direct expenses associated with issuing stock, such as underwriting fees, as well as the

opportunity cost of the dilution of existing shareholders' ownership. The cost of external equity is also known as the cost of equity

capital and can be estimated using various financial models such as the Capital Asset Pricing Model (CAPM) or the Dividend

Discount Model (DDM).

WACC

WACC stands for Weighted Average Cost of Capital, it is a financial metric that represents the average cost of all the capital a

company has raised (both debt and equity). It is used to estimate the cost of financing a project or investment and is calculated as a

weighted average of the cost of equity and the after-tax cost of debt.
9.1 Calculate the after-tax cost of debt under each of the following conditions:

a. rd of 13%, tax rate of 0%

b. rd of 13%, tax rate of 20%

c. rd of 13%, tax rate of 35%

A) rd of 13%, tax rate of 0%

The after-tax cost of debt is calculated as follows:

After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)

Given that the pre-tax cost of debt (rd) is 13% and the tax rate is 0%, the after-tax cost of debt is:

After-tax cost of debt = 13% * (1 - 0%) = 13%

So, the after-tax cost of debt is 13%.

B) rd of 13%, tax rate of 20%

The after-tax cost of debt is calculated as follows:

After-tax cost of debt = Pre-tax cost of debt * (1 - Tax rate)

Given that the pre-tax cost of debt (rd) is 13% and the tax rate is 20%, the after-tax cost of debt is:

After-tax cost of debt = 13% * (1 - 20%) = 10.4%

So, the after-tax cost of debt is 10.4%.

C) rd of 13%, tax rate of 35%

The after-tax cost of debt is calculated as follows:

rd * (1 - tax rate) = 13% * (1 - 0.35) = 8.55%

So, the after-tax cost of debt is 8.45%.

9.2 The after-tax cost of debt can be calculated as follows:

Cost of debt (before tax) = Yield to maturity

Cost of debt (after-tax) = Cost of debt (before tax) * (1 - Tax rate)

So,

Cost of debt (after-tax) = 8% * (1 - 0.35) = 5.2%

Therefore, LL's after-tax cost of debt is 5.2%.

9.3 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?

The cost of preferred stock, rps, can be calculated as:

Dividend yield: rps = annual dividend per share / price per share = $4.50/$50 = 0.09 or 9%.

9.4 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?

Market price per share: $70

Dividend per share: $60 x 6% = $3.6

Yield: $3.6/$70 = 5.14%

Flotation cost: $60 x 5% = $3

Issue price per share: $60 - $3 = $57

Cost of preferred stock: ($3.6/$57) x 100% = 6.75%

9.5 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?

The cost of common equity can be calculated using the Gordon Growth Model:

Cost of common equity = D1 / P0 + g

Where: D1 = expected dividend at the end of the year ($3.00) P0 = current stock price ($36) g = expected constant growth rate of

dividends (5%)

Plugging in the values: Cost of common equity = $3.00 / $36 + 0.05 = 0.083 or 8.3%

So, the cost of common equity for Summerdahl Resort is 8.3%

9.6 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?

The estimated cost of common equity using the CAPM is 13.9%:

Cost of Equity = Risk-free rate + Beta * (Market return - Risk-free rate) Cost of Equity = 4% + 0.8 * (15% - 4%) Cost of Equity =

4% + 0.8 * (11%) Cost of Equity = 4% + 8.8%

Cost of Equity = 13.9%

9.7 Shi Importers’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?

Solution:

The weight of debt in Shi's target capital structure is 0.30. The cost of debt (rd) is 6%. So, the weight of debt times the cost of debt =

0.30 * 0.06 = 0.018.

The weight of preferred stock in Shi's target capital structure is 0.05. The cost of preferred stock (rps) is 5.8%. So, the weight of

preferred stock times the cost of preferred stock = 0.05 * 0.058 = 0.0029.

The weight of common equity in Shi's target capital structure is 0.65. The cost of common equity (rs) is 12%. So, the weight of

common equity times the cost of common equity = 0.65 * 0.12 = 0.078.

Finally, the WACC is the weighted average of the cost of each component, which is the sum of the product of each component's

weight and cost:

WACC = 0.018 + 0.0029 + 0.078 = 0.107 or 10.7%.

9.8 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?

Cost of equity can be calculated using the formula: Cost of equity = Rf + Beta * (Market return - Rf)

Since the WACC (9.96%) is given, we can use the following equation to calculate cost of equity: WACC = (40% * Cost of debt *

(1-tax rate)) + (60% * Cost of equity)

Rearranging the equation and solving for cost of equity: Cost of equity = (WACC - (40% * Cost of debt * (1-tax rate))) / (60%)

Cost of debt = 9% (given)

Cost of equity = (9.96% - (40% * 9% * (1-0.40))) / (60%) = 11.52%

9.9 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.)

The after-tax cost of debt is calculated as follows:

Coupon payment = $1,000 * 6% = $60 Yield to maturity = (Coupon payment / Bond price) * 2 = (60 / 515.16) * 2 = 0.1159 or

11.59% Tax shield = Coupon payment * (Tax rate) = 60 * 40% = 24 After-tax coupon payment = Coupon payment - Tax shield =

60 - 24 = 36 After-tax yield = (After-tax coupon payment / Bond price) * 2 = (36 / 515.16) * 2 = 0.0696 or 6.96%

So the firm's after-tax component cost of debt for WACC calculation is 6.96%
9.10 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? 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? 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-judgmental-risk-premium approach? (Hint: Use the

midpoint of the risk premium range.) d. On the basis of the results of parts a through c, what would be your

estimate of Shelby’s cost of equity?

a. Cost of equity using discounted cash flow approach: Dividend discount model formula: ke = D1/(P0) + g where: D1 = next year's

dividend = $2.14 P0 = current stock price = $23 g = expected growth rate = 7% ke = (2.14 / 23) + 0.07 = 0.0935 or 9.35%

b. Cost of equity using CAPM approach: ke = Rf + β(E(rm) - Rf) where: Rf = risk-free rate = 9% β = beta = 1.6 E(rm) = expected

return on market = 13% ke = 9 + 1.6(13 - 9) = 15.4%

c. Cost of equity using own-bond-yield-plus-judgmental-risk-premium approach: Risk premium = E(rm) - Rb = 13 - 12 = 1%

(midpoint of range) ke = Rb + Risk premium = 12 + 1 = 13%

d. Final estimate of cost of equity: As all three methods provide different results, a weighted average of these estimates can be taken

to arrive at a final estimate of cost of equity:

ke = (9.35% + 15.4% + 13%) / 3 = 12.13%

9.11 Radon Homes’s current EPS is $6.50. It was $4.42 5years 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.) b. Calculate the next expected dividend per share, D1. (Hint: D0 = 0.4($6.50) = $2.60.) Assume

that the past growth rate will continue. c. What is Radon’s cost of equity, rs?

a. To calculate the historical growth rate in earnings, we can use the formula: Growth rate = (Current EPS - EPS 5 years ago) / EPS

5 years ago) * 100 Growth rate = ($6.50 - $4.42) / $4.42 * 100 = 47.01%

b. To calculate the next expected dividend per share, D1, we can use the formula: D1 = D0 (1 + Growth rate) D0 = 0.4 * $6.50 =

$2.60 D1 = $2.60 * (1 + 47.01%) = $3.83

c. To calculate Radon's cost of equity, rs, we can use the Gordon growth model: rs = D1 / P0 + g Where g = Growth rate = 47.01%

P0 = Current stock price = $36 rs = $3.83 / ($36 + (47.01% * $36)) = 10.67%

Therefore, Radon's cost of equity, rs is 10.67%.

9.12 Spencer Supplies’s 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? 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.

a. If investors require a 9% return, then the expected rate of growth must be: g = 9% - (3.60/60) = 9% - 0.06 = 3%

b. If Spencer reinvests earnings in projects with average returns equal to the stock’s expected rate of return, then the next year's

EPS is: Next Year's EPS = (1 + g) * (5.40) = (1 + 0.03) * (5.40) = $5.57

9.13 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?

Solution:

The cost of external equity (re) can be calculated using the Gordon Growth Model:

re = D1 / (P0 - flotation cost) + g

where: D1 = expected dividend per share = $3.00 P0 = issue price = $30 flotation cost = 10% of $30 = $3 g = expected growth in

dividends = 5%

re = $3 / ($30 - $3) + 5% re = 0.0923 or 9.23%

So the cost of external equity for Messman Manufacturing is 9.23%.9.14

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.

The after-tax cost of debt can be calculated as follows:

Pretax cost of debt = Coupon rate = 9%

After-tax cost of debt = Pretax cost of debt * (1 - Tax rate) = 9% * (1 - 0.4) = 5.4%

So, the after-tax cost of debt is 5.4%.

9.15 Please solve the following problem from the cost of capital chapter

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?

b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of

equity, what is its WACC?

c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what

will happen to the WACC?No numbers are required to answer this question.

a. To maintain the present capital structure, Tysseland must finance half of the new investment with common equity, which is $30

million * 50% = $15 million.

b. WACC is calculated by weighting the cost of each component of the capital structure by its proportion in the capital structure and

taking the average. WACC = (Debt weight * Cost of debt) + (Equity weight * Cost of equity) Debt weight = Debt / (Debt + Equity)

= $30 million / ($30 million + $30 million) = 50% Equity weight = Equity / (Debt + Equity) = $30 million / ($30 million + $30

million) = 50% Cost of debt = 8% Cost of equity = Dividend yield + (Expected growth rate * P/E) = 4% + (8% * $30/$1.20)

= 16% WACC = (50% * 8%) + (50% * 16%) = 12%.

c. If Tysseland must issue new shares of stock, the number of outstanding shares will increase and the market value of the equity

component will increase. As a result, the cost of equity will go up, since the market's required return on equity will be spread over a

larger number of shares. This increase in the cost of equity will lead to an increase in the WACC.
9.16 Suppose the Schoof Company has this book value balance sheet:

Current assets $ 30,000,000 Current liabilities $ 20,000,000 Notes payable $ 10,000,000 Fixed assets 70,000,000 Long-term debt

30,000,000 Common stock (1 million shares) 1,000,000 Retained earnings 39,000,000 Total assets $100,000,000 Total liabilities

and equity $100,000,000

The notes payable are to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. These bank loans

are not used for seasonal financing but instead are part of the company’s permanent capital structure. The long-term debt consists of

30,000 bonds, each with a par value of $1,000, an annual coupon interest rate of 6%, and a 20-year maturity. The going rate of

interest on new long-term debt, rd, is 10%, and this is the present yield to maturity on the bonds. The common stock sells at a price

of $60 per share. Calculate the firm’s market value capital structure.

Market value of notes payable: $10,000,000 x (1 + 10%) = $11,000,000

Market value of long-term debt: $30,000 x $1,000 x (1 + 10%) = $33,000,000

Market value of common stock: 1,000,000 x $60 = $60,000,000

Total market value of liabilities: $11,000,000 + $33,000,000 + $20,000,000 = $64,000,000

Total market value of equity: $60,000,000 + $39,000,000 = $99,000,000

Total market value of liabilities and equity: $64,000,000 + $99,000,000 = $163,000,000