CHAPTER 8: RISK AND COST OF CAPITAL

Exercise 1:
A company is 40% financed by risk-free debt. The interest rate is 10%, the expected
market risk premium is 8%, and the beta of the company’s common stock is .5.
What is the company cost of capital? What is the after-tax WACC, assuming that the
company pays tax at a 35% rate?
Exercise 2:
The total market value of the common stock of the Okefenokee Real Estate
Company is $6 million, and the total value of its debt is $4 million. The treasurer
estimates that the beta of the stock is currently 1.5 and that the expected risk
premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity
that Okefenokee debt is risk- free and the company does not pay tax.
a. What is the required return on Okefenokee stock?
b. Estimate the company cost of capital and WACC.
Exercise 3:

The amount of each

Sources of fund Figures
source of fund
Long term debt from The bank charges HGM the
$900,000
bank interest rate of 13%.
Consider to issue 10% coupon
bond with a face value of
Bond $1,000,000
$1,400, price of bond is $1,000,
and 5 years to maturity.
If the risk-free rate is 4%, the
expected market risk premium
Stock $200,000
is 8%, and the company’s stock
beta is 1.2.
Estimate WACC, tax rate is 30%.
Exercise 4:

Long term debt outstanding $600,000

Current yield to maturity 8%
Number of shares of common stock 15,000
Price per share $100
Book value per share $50
Expected rate of return on stock 13%

Calculate WACC. Tax rate is 30%

Exercise 5:
A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. Risk free
rate is 5%, the estimated risk premium on the market is 10%, and the project has a
beta of 0.7.
If you use a constant risk-adjusted discount rate, what is
a) The PV of the project?
b) The certainty-equivalent cash flow in year 1 and year 2?
c) The ratio of the certainty-equivalent cash flows to the expected cash flows in
years 1 and 2?
Exercise 6:
A levered firm has a target capital structure of 20 percent debt and 80 percent equity.
The aftertax cost of debt is 6 percent, the tax rate is 35 percent, and the cost of
equity is 13 percent. The firm is considering a project that is equally as risky as the
overall firm. The project has an initial cash outflow of $1 million and annual cash
inflows of
$460,000 at the end of each year for three years. What is the NPV of the project?
Exercise 7:
Alaskan Markets has a target capital structure of 40 percent debt and 60 percent
equity. The pretax cost of debt is 6 percent, the tax rate is 30 percent, and the cost of
equity is 12 percent. The firm is considering a project that is equally as risky as the
overall firm. The project has an initial cash outflow of $2.3 million and annual cash
inflows of $700,000 at the end of each year for four years. What is the NPV of the
project?
Exercise 8:
Nero Violins has the following capital structure:

Security Cost of capital Total Market Value

($ millions)
Long term bond 11% 100
Long term loan 14% 250
Common Stock 10% 150

What is the firm’s WACC? Tax rate is 30%

Exercise 9:
Based on WACC, choose the optimal capital structure of ABC company, corporate
tax rate is 20%:
 Proportion of Debt Cost of Debt Proportion of Equity Cost of Equity
(D/V) (rd) (E/V) (re)
0% 0 100% 12%
10% 9.60% 90% 12%
30% 9.60% 70% 12%
60% 12% 40% 15%

Exercise 10:
Suppose the Widget Company has a capital structure composed of the following, in
billions:
Debt €10
Common equity €40

If the before-tax cost of debt is 9%, the required rate of return on equity is 15%, and
the tax rate is 30%, what is Widget’s weighted average cost of capital?

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THE END