61FIN2FIM - FINANCIAL MANAGEMENT

TUTORIAL 8– COST OF CAPITAL

Part 1: Indicate whether each of the following statement is TRUE or FALSE.

1. Capital refers to items on the right-hand side of a firm's balance sheet

TRUE FALSE

2. The component costs of capital are market-determined variables in as much as they are based on
investors' required returns.

TRUE FALSE

3. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding
debt

TRUE FALSE

4. The correct discount rate for a firm to use in capital budgeting, assuming that new investments are of the
same degree of risk as the firm's existing assets, is its marginal cost of capital.

TRUE FALSE

5. Each component cost of particular types of capital is identical for each source of funds found in a firm's
capital structure.

TRUE FALSE

6. The cost of debt, rD, is always less than rs, so rD(1 – Tc) will certainly be less than rs. Therefore, since a firm
cannot be 100% debt financed, the weighted average cost of capital will always be greater than rD(1 – Tc).

TRUE FALSE

7. The after tax cost of debt is used to calculate the weighted average cost of capital since we are concerned
with the after-tax cash flows of the firm.

TRUE FALSE

8. A firm's capital structure has no impact on the firm's weighted average cost of capital

TRUE FALSE

Part 2 – Questions & problems

1. The Heuser Company’s currently outstanding bonds have a 10% coupon and a 12% yield to maturity.
Heuser believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal
tax rate is 35%, what is Heuser’s after-tax cost of debt?

Answer

rD = 12%

Tc = 35%

After tax rD = 12% x (1-35%) = 7.80%

2. Tunney Industries can issue perpetual preferred stock at a price of $47.50 a share. The stock would pay a
constant annual dividend of $3.80 a share. What is the company’s cost of preferred stock, rp?

Answer

rP = $3.80/$47.50 = 8%

3. Javits & Sons’common stock currently trades at $30.00 a share. It is expected to pay an annual dividend of
$3.00 a share at the end of the year, and the constant growth rate is 5% a year. What is the company’scost
of common equity if all of its equity comes from retained earnings?

Answer

rs = $3/$30 + 5% = 15%

4. Midwest Water Works estimates that its WACC is 10.5%. The company is considering the following capital
budgeting projects:

Assume that each of these projects is just as risky as the firm’s existing assets and that the firm may accept
all the projects or only some of them. Which set of projects should be accepted? Explain.

Answer

Rates of return of projects A, B, C, D, and E are all greater than their costs of capital WACC = 10.5%. Thus,
they are accepted.

Rates of return of project F and G are smaller than their costs of capital WACC = 10.5%. Thus, they are
rejected.

5. Patton Paints Corporation has a target capital structure of 40% debt and 60% common equity, with no
preferred stock. Its before-tax cost of debt is 12%, and its marginal tax rate is 40%. The current stock price is
$22.50. The last dividend was $2.00, and it is expected to grow at a 7% constant rate. What is its cost of
common equity and its WACC?

Answer

rs = 2*(1+7%)/22.5 +7% = 16.51%

WACC = 0.4*12%*(1-40%)+0.6*16.51%= 12.79%

6. The Patrick Company’s year-end balance sheet is shown below. Its cost of common equity is 16%, its
before-tax cost of debt is 13%, and its marginal tax rate is 40%. Assume that the firm’s long-term debt sells at
par value. The firm has 576 shares of common stock outstanding that sell for $4.00 per share. Calculate
Patrick’s WACC using market value weights.

Answer

VD = $1,152

VE =$4*576=2,304

WD = $1,152/($1,152+$2,304) = 1/3

WE = 2/3

WACC = 1/3*13%(1-40%) + 2/3*16% = 13.27%

7. Midwest Electric Company (MEC) uses only debt and common equity. It can borrow unlimited amounts at
an interest rate of 10% as long as it finances at its target capital structure, which calls for 45% debt and 55%
common equity. Its last dividend was$2, its expected constant growth rate is 4%, and its common stock sells
for $20. MEC’s tax rate is 40%. Two projects are available: Project A has a rate of return of 13%, while Project
B’s return is 10%. These two projects are equally risky and about as risky as the firm’s existing assets. Which
projects should Midwest accept?

Answer

rs = $2*(1+4%)/$20+4% = 14.4%

WACC = 0.45*10%*(1-40%)+0.55*14.4% = 10.62%

Project A: IRR = 13% and greater than WACC >>> selected

Project B: IRR =10% and smaller than WACC >>> rejected.

8. Adams Corporation is considering four average risk projects with the following costs and rates of return:

Amount in thousand (e.g. $2,000 means $2,000 thousand or $2million). Currently the company has no debt
and preferred stocks.
The company estimates that it can issue 2,000 new bonds at a rate of 10%, coupon rate of 8% and its tax rate
is 30%. The bond will mature in 10 years. It can issue 37,145 new preferred stocks that pay a constant
dividend of $5.00 per year at $40.00 per share. Also, its common stock (total 50,000) currently sells for
$36.00 per share; the next expected dividend is $3.60; and the dividend is expected to grow at a constant
rate of 6% per year. After the new issues, the company reaches its target capital structure.

a. What is the cost of each of the capital components?

b. What is the value of each of the capital components?

c. What is Adams’ WACC?

d. Only projects with expected returns that exceed WACC will be accepted. Which projects should Adams
accept?

Answer

A.

rD = 10%

rs = $3.6/$36+6%=16%

rp = $5/$40 = 12.5%

B.

Price of a bond = 80/10%x[1-1/(1+10%)^10) + 1,000/(1+10%)^10 = $877.11

VD = 2,000*877.11 = $1,754,217.32

Vs = 50,000*36 =$1,800,000

Vp = 37,145*40 = $1,485,800

C.

WACC = (1,754,217.32/5,040,017.32)*10%*(1-30%)+(1,485,800/5,040,017.32)*12.5% +
(1,800,000/5,040,017.32)*16% = 11.66%

D.

All projects will be accepted b/c their returns are greater than WACC.