FINANCIAL MANAGEMENT

CHAPTER 7: 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
$800,000
bank interest rate of 12%.
Consider to issue 10% coupon
bond with a face value of
Bond $1,000,000
$1,500, price of bond is $1,000,
and 5 years to maturity.
If the risk-free rate is 4%, the
expected market risk premium is
Stock $200,000
8%, and the company’s stock
beta is 1.62.
Estimate WACC, tax rate is 30%.
Exercise 4:

Long term debt outstanding $500,000

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 12%

Calculate WACC. Tax rate is 30%

GVTH: PhD Le Bao Thy - Page 1 of 4

 FINANCIAL MANAGEMENT

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 0.5.
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 14 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
$450,000 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 35 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 $2.5 million and annual cash
inflows of $800,000 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 12% 100
Long term loan 14% 250
Common Stock 10% 150

What is the firm’s WACC? Tax rate is 20%

GVTH: PhD Le Bao Thy - Page 2 of 4

 FINANCIAL MANAGEMENT

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?
Exercise 11:
An all-equity firm has a beta of .68. The firm is evaluating a project that will increase
the output of the firm's existing product. The market risk premium is 5.3 percent and
the risk-free rate is 3.8 percent. What discount rate should be assigned to this
expansion project?
Exercise 12:
The market value of Charter Cruise Company's equity is $20 million, and the market
value of its risk-free debt is $15 million. If the required rate of return on the equity is
15% and that on the debt is 6%, calculate the company's cost of capital. (Assume no
taxes.)
Exercise 13:
The historical returns data for the past three years for Stock B and the stock market
portfolio are: Stock B: 16%, 10%, 26%, Market Portfolios: 13%, 12%, 20%. Calculate
the required rate of return (cost of equity) for Stock B using CAPM. (The risk-free rate
of return = 3%)
Exercise 14:
A firm has a beta of 1.3 and a debt-to-equity ratio of .5. The market rate of return is
11.5 percent, the tax rate is 30 percent, and the risk-free rate is 5.6 percent. The pretax
cost of debt is 7.8 percent. What is the firm's WACC?
Exercise 15:

GVTH: PhD Le Bao Thy - Page 3 of 4

 FINANCIAL MANAGEMENT

The Red Hen currently has a debt-to-equity ratio of .42, its cost of equity is 16.2
percent, and its beta is 1.68. The pretax cost of debt is 6.3 percent, the tax rate is 20
percent, and the risk-free rate is 3.6 percent. The firm's target debt-to-equity ratio is
.4. What discount rate should be assigned to a new project the firm is considering if
the project is equally as risky as the overall firm and will be financed solely with debt?
Exercise 16:
The historical returns data for the past three years for Company A's stock is -6.0%,
18%, 15% and that of the market portfolio is 13%, 13% and 16%. If the risk-free rate
of return is 3.5%, what is the cost of equity capital (required rate of return of company
A's common stock) using CAPM?


THE END

GVTH: PhD Le Bao Thy - Page 4 of 4