The German University in Cairo (GUC) Winter 2023

Faculty of Management Technology Dr. Hadeer Mounir

Finance Department Corporate Finance

Tutorial 2

Chapter 9: The Cost of Capital (Continued)

Question 1
Ross Textiles wishes to measure its cost of common stock equity. The firm’s stock is currently
selling for $57.50. The firm expects to pay a $3.40 dividend at the end of the year (2018). The
dividends for the past 5 years are shown in the following table.
Year Dividend
2017 $ 3.10
2016 2.92
2015 2.60
2014 2.30
2013 2.12
For new issuance of common stock, the firm expects the stock to be undervalued by $3.00 per
share in addition to flotation costs of $2.50 per share.
a. Determine the growth rate of dividends from 2013 to 2017.
b. Using the Gordon Valuation Model, determine the cost of retained earnings, rr.
c. Using the Gordon Valuation Model, determine the cost of new common stock, rn.

Question 2
The risk-free rate is 6%, and the market return is 11%. Determine the risk premium in the
market and on J&M’s common stock. Additionally, calculate the rate of return that J&M
common stock should provide based on the following different scenarios:
a. J&M Corporation common stock has a beta b, of 1.2.
b. J&M Corporation common stock has a beta b, of 1.
c. J&M Corporation common stock has a beta b, of 0.6
The German University in Cairo (GUC) Winter 2023
Faculty of Management Technology Dr. Hadeer Mounir
Finance Department Corporate Finance

Question 3

Lang Enterprises is interested in measuring its overall cost of capital. Current investigation
has gathered the following data. The firm is in the 40% tax bracket.

Debt: The firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year
bonds on which annual interest payments will be made. To sell the issue, an average
discount of $30 per bond would have to be given. The firm also must pay flotation costs of
$30 per bond.

Preferred stock: The firm can sell 8% preferred stock at its $95-per-share par value. The
cost of issuing and selling the preferred stock is expected to be $5 per share. Preferred stock
can be sold under these terms.

Existing Common stock: The firm’s common stock is currently selling for $90 per share.
The firm expects to pay cash dividend of $7 per share next year growing at a constant rate
indefinitely. Lang Enterprise’s ROE is 10% and maintain a payout ratio of 40%

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.
c. Calculate the common stock growth rate.
d. Calculate the cost of common stock equity.
e. Calculate the firm’s weighted average cost of capital using the book value weights.

Source of capital Book Value

Long term debt $75,053,000

Preferred Stock $112,579,500
Common Stock $187,632,500
Total $375,265,000

f. Given the following investment opportunities, which project may be accepted by the
financial manager?

Project Expected Return

A 10%
B 12.8%
C 8.5%