Cost of Capital - Solutions1. When calculating a WACC for a company with preferred stock, there is no need to adjust the cost of the preferred stock to reflect the tax exclusion of 70% of the preferred stock dividend. * A. B. 2. A firm can only have one break point in its marginal cost of capital curve, which will occur when they deplete their additions to retained earnings and must switch over to new issues of equity. * A. B. True False True False 3. Because creditors can foresee, to at least some extent, the costs of bankruptcy, they charge a higher rate of interest to compensate for the present value of bankruptcy costs. * A. B. 4. Increasing a company’s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company’s WACC. * 5. * 6. * 7. A. B. True False True False Although quite rare, the mathematics is such that the after-tax component cost of debt financing can be greater than the after-tax component cost of equity financing. A. B. True False The cost to the firm of retained earnings is zero, since they are generated from the current earnings of the firm and there are no flotation costs associated with their retention. A. B. True False If we assume that the stock market is efficient, and if we assume that Stock A has a beta of 1.20, while Stock B has a beta of 1.40 (that is, B has higher risk than A), then we must also assume that the required rate of return on Stock B exceeds the required rate of return on Stock A. Old Exam Questions - Cost of Capital - Solutions Page 1 of 42 Pages * A. B. 8. If a firm must pay flotation expense when issuing a security, then the firm’s required rate of return on that security will be greater than the investor’s required rate of return for that security. * A. B. 9. The easiest way to correctly calculate the firm’s cost of debt is simply to multiply the coupon rate on the debt times one minus the firm’s tax rate. * 10. * 11. * 12. A. B. True False True False True False The cost of equity capital from the sale of new common stock (re) is generally equal to the cost of equity capital from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 - F). A. B. True False If expectations for long-term inflation rose, but the slope of the SML remained constant, this, for most firms, would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd. In other words, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. (Hint: play with some numbers and see what happens.) A. B. True False If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, it would probably encourage companies to use more debt financing than they presently do, other things held constant. * A. B. True False 1. Which of the following statements is not (or least) correct? * A. Because of the tax shelter created by issuing preferred stock dividends (remember that 70 percent of dividends are excluded from taxes), the firm’s Old Exam Questions - Cost of Capital - Solutions Page 2 of 42 Pages B. C. D. E. after-tax cost of preferred stock may be significantly less than its before-tax cost. The weighted average cost of embedded/historical capital (capital already raised by the firm) will have little significance when the firm looks at taking on new projects that will require them to issue additional capital. Assume that a firm is comprised of two divisions that differ significantly in risk and, therefore, in terms of their divisional screening rates. If the firm evaluates all investments by using a weighted average corporate cost of capital (rather than using divisional screening rates), the firm is likely to become more risky by taking on more of the higher-risk projects and become less valuable by taking on projects that earn a rate of return that is less than what they should be earned based on the actual risk of the project. Flotation costs may not be a significant factor for a firm’s bonds, since many bond issues are privately placed (sold to institutional investors) with minimal administrative expense. That is, the firm essentially nets what the institutional investor pays. Flotation costs may be a significant factor when a firm issues new shares of common stock. If so, the firm’s cost of equity (new issues of common stock) will be higher than the firm’s cost of retained earnings, but the firm’s cost of retained earnings will still be equal to the investors’ required rate of return on the firm’s common stock. 2. If a U.S. company with two divisions, one very risky and the other with significantly less risky, uses the same corporate discount rate to evaluate all projects, the most likely outcome, as discussed in class, is that the firm will become: * A. B. C. D. E. 3. A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should: A. B. C. D. Riskier over time, and its value will decline. Riskier over time, and its value will rise. Less risky over time, and its value will rise. Less risky over time, and its value will decline. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate. Increase the IRR of the asset to reflect the greater risk. Increase the NPV of the asset to reflect the greater risk. Reject the asset, since its acceptance would increase the risk of the firm. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project. * E. 4. Select the statement that is most correct. Old Exam Questions - Cost of Capital - Solutions Page 3 of 42 Pages A. B. * C. D. E. 5. Select the statement that is most correct. A. * B. C. D. E. 6. B. C. D. E. 7. When a bond’s coupon rate is greater than its yield to maturity, the coupon rate should be used as the firm’s before-tax cost of debt. All other things equal (including component costs), a higher tax rate will lower a firm’s WACC only if the firm uses debt financing. While higher-than-average risk projects require discounting cash flows at a rate above the firm’s WACC, it is usually not appropriate to discount lower-thanaverage risk projects at a rate below the firm’s WACC. Even if project risks vary widely within a firm, a project’s cash flows should always be discounted at the corporate cost of capital (WACC). Because of the sheer size of large, publicly traded firms, it is more difficult to use the CAPM to estimate their cost of equity than to estimate it for small, privately held firms. Which of the following statements is most correct? A. * Since most stock is privately placed, a firm’s required rate of return for a new issue of common stock will be equal to the investors’ required rate of return for that same issue. The WACC represents the historical cost of capital and is usually calculated on a before-tax basis. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible. An increase in the corporate tax rate, all other factors held constant, should lead to an increase in a firm’s weighted average cost of capital. A firm can lower its component cost of debt simply by issuing debt with a lower coupon rate. The “enterprise” value of the firm can be found by taking the free cash flow available to all investor’s and discounting it at the firm’s weighted average cost of capital. Since most equity is privately placed for publicly traded corporations, flotation costs are negligible, and the firm’s cost of a new issue of common stock will be, therefore, essentially the same as the investor’s required rate of return. Since the market value of the firm’s debt and equity will continuously change throughout the day, and since the firm’s book value of debt and equity is much more stable over time, the firm should use book value weight to define its optimal capital structure. Which of the following statements is most correct? Old Exam Questions - Cost of Capital - Solutions Page 4 of 42 Pages all other factors held constant. A decrease in the risk-free rate.Cost of Capital . all else equal. The cost of equity raised by retaining earnings can be less than. is used as the component cost of debt for purposes of developing the firm's WACC. A. which is lower than the after-tax cost. The before-tax cost of debt. Typically. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same. 9. B.* A.000 by issuing $6. depending on tax rates. If the beta of a company’s equity decreases.000 of debt at a Old Exam Questions .000. then. C. will likely increase the marginal costs of both debt and equity securities. 8.Solutions Page 5 of 42 Pages . The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. Which of the following statements is correct (most correct)? A. equal to. the cost of retained earnings is usually much cheaper that the cost of debt financing. All of the statements above are incorrect. The total return on a share of stock refers to the dividend yield less any commissions paid when the stock is purchased and sold. Since there are no flotation costs associated with it. B. If a company’s tax rate increases then. the firm’s WACC should decrease. Since the firm retains any earnings that are not needed to be paid out as dividends. C. * E. it is possible for a company to achieve a lower WACC by issuing new shares of common stock to meet its equity needs. then. rather than relying upon retained earnings to meet those needs. B. Select the statement that is most correct. a company needs to adjust for taxes. When calculating the cost of preferred stock. Also assume that the firm raised the $20. 1. because preferred stock dividends are tax deductible for the issuing firm. all else equal. * E. the before-tax cost of debt financing exceeds the after-tax cost of equity financing. A company’s targeted capital structure will affect its cost of capital. D. D. C. E. even when flotation costs have been accounted for. and other factors. or greater than the cost of external equity raised by selling new issues of common stock. the attitude of investors. The component costs of capital are market-determined variables in as much as they are based on investors' required returns. Changes from the target may cause the weighted average cost of capital to either increase or decrease. flotation costs. the cost of retained earnings will always be less than the after-tax cost of debt financing. the company’s weighted average cost of capital will also increase. D. Assume that a firm takes on a project that requires an initial investment in Year 0 of $20. they will sell for $44 per share.3% 7.9% WACC = (. The company expects to pay a dividend on its common stock of $2.40) = 4. Your firm has estimated that it will spend $10 million on new capital budgeting projects during the coming year.8% Old Exam Questions . D.009 + .000 of equity at a cost of equity of 10%. New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt.000 40% 40% 20% After-tax KD = (8%)(1-. 8. The company’s tax rate is 40 percent. but the firm will have to pay flotation expense of 10%. The company’s ROE is 10% and its dividend payout rate is 50%.598% 8.07 = 7. B.000 Retained Earnings = $4.319% 8. 7.000)(. What is the WACC of the entire $10 million to be raised? * A. If the tax rate is 40%.$4 .10)(70%) = . C. B.2.5% 7.000. The market risk premium is 5 percent. The company has corporate bonds outstanding with an 8 percent annual coupon that are trading at par. then what is the weighted average cost of capital (WACC) for this project? * A.Cost of Capital . Each of the project’s to be taken on has the same degree of risk as the current projects of the firm.$4) = $2.000.Solutions Page 6 of 42 Pages .000.678% 8. If the firm issues new shares of common stock. and issued $14. C. You have been asked to calculate the appropriate cost of capital to be used to analyze these projects and have collected the following information: • • • • • • • • • • • • • Your firm’s targeted capital structure consists of 40 percent debt and 60 percent common equity.05)(1-. E. Your firm expects to add $4 million to retained earnings over the coming year that can be used to support the $10 million in new projects. The risk-free rate is 4 percent.000.7% 8.712% Breakdown: Debt = ($10. D.1% 8.000 New Equity = ($10 .9% 2.20 per share next year (D1). The current stock price (P0) is $44 per share. The stock’s beta is 1.before-tax cost of debt of 5%.4)(30%) + (.40) = $4. E.032% 8. 0%)(0.05)(1.65% 5.464097130% KD = (4.Cost of Capital .05 + 0.00 + 0.20) = 1.05 = 10.92% + 4. D.032% 3.80% 5. which is considered to be optimal. E.95% Net Price = ($980) (1 . If the firm has a marginal corporate tax rate of 35%.000 Solve for I/YR = 4.02) = $960. B.10)(1 – 0.35% 5.00)(1-0.8%)(0.464097130) (2) = 8. C. g = (0. Your firm’s investment bankers have stated that the bonds can be sold publicly to investors at a price of $980 per bond..2) = 10% Alternatively.10) + 0.928194260% After-tax KD = (8.50% 5.50) = 5% KS = $2.000.80% YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 4 .05 = 0.Solutions Page 7 of 42 Pages .40 N = 40 PV = -$960. 5.56%)(0. * Your company plans to issue debt with an annual coupon rate of 8.5% (interest paid semi-annually) and which will mature in 20 years at a par value of $1.20 / ($44.35) = 5.112% = 8.803326269% = 5.05 = 10% Ke = $2.50 FV = $1.04 + (0.5: Your company's current market-valued capital structure. then what will be the firm’s after-tax cost on this new debt to be issued? A.40) + (10.20 / $44.56% Therefore.KS = 0.40) + (10.928194260) (1 – 0.0% + 2. but that the firm will be required to pay a flotation expense to the investment bankers equal to 2% of this price. WACC = (4. is shown below: Old Exam Questions .40 PMT = ($85 / 2) = $42. Preferred: 8% for the first $500.2% Debt Preferred RE 5.00% 8.00% What is the weighted average cost of capital for the entire $5. 15% for up to an additional $2. E.00 x 12. and 4.000 of new preferred.72% 8. Net Income is expected to be $550.000 After-tax Costs of Debt: 3. What is the weighted average cost of capital for the very first dollar to be raised? A.000.6%. 3.000 of new preferred. and the before-tax costs of new financing are estimated to be: 4. 6% for up to an additional $1. * 40% 10% 50% x 3.$50. 9% for up to an additional $500. D.000 next year.0%.72% 8.0%. 7% for up to an additional $1. The common stock dividend payout rate is 40% of the profit after the payment of preferred dividends.000 of new common stock.000.Solutions Page 8 of 42 Pages .51% After-tax Costs of Debt: 3. However.Cost of Capital .2% Old Exam Questions .4) = $300. The corporate tax rate is equal to 40%.000. * Debt: 5% for the first $500.00% 8.51% RE = ($550. 3.00 x 8.6%.000.00%.80% 6.000 of new debt.000 of new common stock.20% 0. the company has decided to raise $5.000 of new debt. and 4. B.000 to be raised for the expansion? A. 8. Equity: 12% for retained earnings.00 = = = 1.34% 8.000. 8. 13% for up to the first $2. D E. B.23% 8.34% 8. C.000 .000 of new common stock. 14% for up to an additional $2. preferred stock dividends are expected to account for $50. 8.000.000)(1-.000 of this profit.000.23% 8.Debt Preferred Stock Equity 40% 10% 50% In order to meet their expansion plans for next year.000 of new debt. C.000. 000 = 10% $1.00 14.08)(1-. 5 percent preferred stock.There are several different ways to do this.000/$5. C. and 60 percent common stock.07)(. C. Calculate the firm’s weighted average cost of capital (WACC). Assume that the firm’s before-tax cost of debt is 6 percent and that its tax rate is 40 percent.42% 10.80% 0. One of them is below.06)(1-.56% 8.20% 0.82% 10.Cost of Capital .00 3.40) + (. Debt Debt Debt Preferred RE Equity Equity 6.000 = 20% $500/$5.72% 5.000 = 40% $200 = 4% x x x x x x x 3.50) = 0.00 = = = = = = = 0.72% 10.10) + (. D.4)(.066 WACC = 8.20 8.00 12. Assume that the firm’s before-tax cost of debt is 8 percent and that its tax rate is 40 percent.4)(.93% WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) WACC = (.00 13.01 + 0.42% 7. * A firm’s optimal capital structure consists of 35 percent debt.0126 + 0.67% 8.42% 0. Also assume that the firm’s cost of preferred stock is 10 percent and that its cost of common stock is 15 percent. A.62% WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) WACC = (. A. * $500/$5. 7. Calculate the firm’s weighted average cost of capital (WACC).21% 7.15)(. E.Solutions Page 9 of 42 Pages . 10.30% 0. B. E.52% 8.11)(.60) = 0.89% 8.60 4.0035 + 0.0192 + 0. Also assume that the firm’s cost of preferred stock is 7 percent and that its cost of common stock is 11 percent.35) + (.72% A firm’s optimal capital structure consists of 40 percent debt.05) + (. B.000 = 10% $500 = 10% $300 = 6% $2.52% 10.21% Old Exam Questions . D. 10 percent preferred stock. and 50 percent common stock.72% 0.075 = 10.10)(. The company’s ROE is 10% and its dividend payout rate is 50%. E. 7.81% 8.61% 8. C. g = (0.41% 8.Cost of Capital .50) = 5% KS = $1. D.000)(.5%.7) = $3. The market risk premium is 5 percent. Your firm expects to add $2. The company has corporate bonds outstanding with a 6 percent annual coupon that are trading at par.71% Therefore.8. You have been asked to calculate the appropriate cost of capital to be used to analyze these projects and have collected the following information: • • • • • • • • • • • • • Your firm’s targeted capital structure consists of 35 percent debt and 65 percent common equity.6% KS = 0.10)(1 – 0.05 = 0. The company expects to pay a dividend on its common stock of $1.00 + 0.Solutions Page 10 of 42 Pages .50 per share next year (D1).000 35% 30% 35% After-tax KD = (6%)(1-.40) = 3.05)(1.000.15 . The risk-free rate is 3 percent.05 = 10.150.4) = 10% Alternatively.03 + (0. Each of the project’s to be taken on has the same degree of risk as the current projects of the firm. The stock’s beta is 1.000 New Equity = ($9 .4.700.$2.35) = $3. Old Exam Questions . but the firm will have to pay flotation expense of 12.50 / $30. Your firm has estimated that it will spend $9 million on new capital budgeting projects during the coming year. The current stock price (P0) is $30 per share.05 = 10% Ke = $1.05 + 0. If the firm issues new shares of common stock. B. What is the WACC of the entire $9 million to be raised? * A. they will sell for $30 per share.21% 8.50 / ($30. New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt.00)(1-0. The company’s tax rate is 40 percent.000 Retained Earnings = $2.150.7 million to retained earnings over the coming year that can be used to support the $9 million in new projects.$3.01% Breakdown: Debt = ($9.125) + 0. 000 of new debt. C.000. 6% for up to an additional $1.005 + (KS)(.25% YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 10 . preferred stock dividends are expected to account for $100.4)(. Preferred: 6% for the first $1.35) + (.0147 . is shown below: Debt Preferred Stock Equity 30% 10% 60% In order to meet their expansion plans for next year.1052 .52%.75% WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) WACC = (.71%)(0.Cost of Capital .. Assume that the firm’s before-tax cost of debt is 7 percent and that its tax rate is 40 percent.01% 9.Solutions Page 11 of 42 Pages .000.35) = 1.000.30) + (10. * A firm’s optimal capital structure consists of 35 percent debt.52% KS = (. B.10)(. and the before-tax costs of new financing are estimated to be: Debt: 4% for the first $2.60) = 10.005) / (.05) + (KS)(. Equity: 10% for retained earnings.000. 14.35) + (10.000.00% 14.WACC = (3.000 of new debt.0%)(0. E. 7% for up to an additional $1. Calculate the firm’s cost of stock (equity).11: Your company's current market-valued capital structure. 5 percent preferred stock. However.60) = .6%)(0.60 = 14. The corporate tax rate is equal to 40%..000 of new preferred.7485% = 8.00% 14.0% + 3.000 of new debt. Old Exam Questions .50% 14.000 of new preferred.07)(1-. D.000. The common stock dividend payout rate is 40% of the profit after the payment of preferred dividends. and 60 percent common stock.25% 15. which is considered to be optimal.60) = 10.0147 + .26% + 3.000. A.0855 / . Net Income is expected to be $1.52% WACC = . Also assume that the firm’s cost of preferred stock is 10 percent and that its weighted average cost of capital is 10. the company has decided to raise $10. 5% for up to an additional $1.000 next year.000 of this profit.000. 460.00 = = = 0. 9.218% Additions to Retained Earnings = ($1.918% 8. D.000) = $6.000 $1.000)(1 .000.000.0% 5.0% 20.Cost of Capital .600% 0.00 6.00 10.000 of new common stock.0% 10.60% 9. E.118% 8.60)($10.000 There are several different ways to do this.000.$100.0% 14.10)($10.4%.000.000 $1.Solutions 20.$100.000 $540.11% for up to the first $2.30)($10.000.300% 0.000. 7. C. B.00 13.000 $2.50% 9.6% x x x x x x x 2.000.40 3.000.480% 0.400% 1.20% 9.0% 10.4) = $540.000. B.000..318% 8. and 3.00 12.60% 7.30% Debt = (. Debt Debt Preferred RE Equity Equity Equity $2.898% 8.000 Equity = (.6% Costs for very last dollar: Debt (3.00 = = = = = = = 0.418% 8. D E.4) = $540.000) = $3. One of them is below.000.540% 2.0%)..30% What is the weighted average cost of capital for the entire $10.000 After-tax Costs of Debt: 2.000.000) = $1.000 to be raised for the expansion? A.00 x 6.000 of new common stock.000 Preferred = (.000 $1.000 Additions to Retained Earnings = ($1. * 30% 10% 60% x 3.90% 0. 12% for up to an additional $2.000. Preferred (6%).000.80% 9.00 11.000.000 $2.000 . 3. Equity (13%) Debt Preferred RE 11.000 . What is the weighted average cost of capital for the very last dollar to be raised? * A.200% 2. C.000.000 = = = = = = = Old Exam Questions .40% 9.000)(1 . 10.000 of new common stock. 13% for up to an additional $2.418% Page 12 of 42 Pages .00 x 13.4% 20.000.0%. $7) + 6% = $4. B. Your company’s CFO is interested in estimating the company's weighted average cots of capital (WACC) and has collected the following information: • • • • • • • The company has bonds outstanding that mature in 18 years with an annual coupon of 7.00/$43 + 6% = 9. B. E.00). C.4 WS = 0.50% Ke = D1/(P0 . The bonds have a face value of $1. giving a before-tax cost of debt of 6. E.00 per share (D1 = $4.24% 7. issue new common stock.90% 15.30% + 6% = 15. Determine the company's cost of equity capital.5 percent (the bond pays $75 on an annual basis).00/($50 . The company has insufficient retained earnings to fund capital projects and must. The dividend is expected to grow at a constant rate of 6 percent per year.Solutions Page 13 of 42 Pages .93% Data given: KRF = 3% RPM = 5% β = 1.120.47% 6.30% 14. C.30% 13. * A. 8.2 The company's tax rate is 40 percent The company's target capital structure consists of 60 percent equity and 40 percent debt The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its cost of capital – it uses the cost of retained earnings.000 and sell in the market today for $1. * A.10% 15.Cost of Capital .F) + g = $4. The new stock has an estimated flotation cost of $7 per share. 15. therefore.12. The risk-free rate is 3 percent The market risk premium is 5 percent The stock's beta is 1.36145%. D. D.6 Step 1: Determine the firm's costs of debt: Old Exam Questions .70% 15. Determine the company’s WACC.2 T = 40% WD = 0.81% 6.39% 7. Your company’s stock currently has a price of $50 per share and is expected to pay a year-end dividend of $4. 4) + (0.000 40. E.50 per share (a slight discount from the current price).0) = $1. 7.000.2 .6)(9%) = 1.200.0 .25. C.5.2 = 9% Step 2: Given the firm's component costs of capital.T) + WSKS = (0.40) = 4.4825% Breakdown: Debt = ($8.5% After-tax KD = (7%)(1-.4)(6.25) and will only net $20.4% = 6.86 per share.40) = $3. • The risk-free rate is 2 percent. PMT = 75.2% Old Exam Questions .000.Cost of Capital . FV = 1000.N = 18. You have been asked to calculate the appropriate cost of capital to be used to analyze these projects and have collected the following information: • Your firm’s targeted capital structure consists of 40 percent debt and 60 percent common equity. Solve for I/YR = KD = 6. What is the WACC of the entire $8 million to be raised? * A.120.5% 22.60 per share next year (D1).0825% 8.000 Retained Earnings = $3. • The current stock price (P0) is $22. = WDKD(1 .0% ($2. calculate the firm's WACC: WACC 14.$3.53% + 5. PV = -1.36145% Determine the firm's costs of equity: KS = KRF + (RPM)(β) = 3% + (5%)1. • New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt.Solutions Page 14 of 42 Pages .2825% 8. they will sell for $22. • If the firm issues new shares of common stock.$3. • The company’s tax rate is 40 percent.36145%)(1 .000 New Equity = ($8.000)(. • The stock’s beta is 1.93% Your firm has estimated that it will spend $8 million on new capital budgeting projects during the coming year. • Your firm expects to add $3.800. • Each of the projects to be taken on has the same degree of risk as the current projects of the firm.6825% 8. • The market risk premium is 6 percent.0 million to retained earnings over the coming year that can be used to support the $8 million in new projects.0% 37. B. D. but the firm will have to pay flotation expense of 10. • The company has corporate bonds outstanding with a 7 percent annual coupon that are trading at par. • The company expects to pay a dividend on its common stock of $1.8825% 8. • The company’s ROE is 10% and its dividend payout rate is 60%.0. D. The company anticipates that its proposed investment projects will be financed with 45 percent debt and 55 percent equity.0% 17. (Hint: you can use regression analysis to find the beta of the firm’s equity.2%)(0. C.8 20.8564.5) = 11% Alternatively.24% WACC = [(0. Interest is paid on an annual basis.10)(1 .) * A. PV = -1. and the expected return on the market is 11.0%)(0.5% 22.35 percent.35 percent.225) = 1.8564.45% 9.4825% 15. Solve for KD = 9% Old Exam Questions .90% WACC = (4.04 = 11.5 24.6775% = 8.04 = 0. (2) Over the past four years.86 + 0.02 + (0.12% 10.Solutions Page 15 of 42 Pages .0 The current risk-free rate is 6. Use bond information to solve for KD: N = 20. A stock analyst has obtained the following information about Z-Mart.68% + 4.45)(KD)(1 .000.125% + 2. The company's tax rate is 35 percent.273.T)] + [(0. g = (0. 9. FV = 1. The bonds have a 12 percent annual coupon and currently sell at a price of $1.KS = 0.90%)(0.60 / $22.7.06)(1.86% 12.0 Z-Mart 14.3.60 / ($22. PMT = 120.Cost of Capital .375) + (11.2 . a large retail chain: (1) The company has noncallable bonds with 20 years maturity remaining and a maturity value of $1.0. E.273.50)(1-.03% 11.40) + (11. B.07 + 0.2 .04 = 11% Ke = $1.000.60) = 4% KS = $1.55)(KS)] A.10) + 0. Determine what the company's estimated weighted average cost of capital (WACC) is. the returns on the market and on Z-Mart were as follows: Year 2000 2001 2002 2003 (3) Market 12. 60% 20. B. D. E.1135 . If the firm believes that it can net $781.00% Answer: C 6.99 from the sale of each bond after any related flotation costs.45)(0.1314)] =0.07227 = 0.74% 20. PV = -781. FV = 1.B.3585) = 0. B. PMT = 40.098595 = 9.1314 = 13.88% Answer: E 20. So Ks = 0.Solutions Page 16 of 42 Pages . and if the firm’s marginal tax rate is 38 percent. If the firm’s marginal tax rate is 38 percent.55)(0. but where interest is paid semi-annually.000. * A firm’s common stock has just paid a dividend (D0) of $1.99.0635 + (0.0635)(1.88% Old Exam Questions . 6. * A firm assumes that it can issue new.82% N = 30.Cost of Capital .46% 20. This dividend is expected to grow at a long-run constant growth rate of 15 percent and investors require a 20 percent rate of return on this stock.0.000 and with an annual coupon rate of 8 percent. Using Market and Z-Mart return information and a calculator's regression feature we find b = 1. To solve for KS. then what is the aftercost of debt to this firm? A.35)] + [(0.09)(1 . 15-year debt with a maturity value of $1. C.50% Annual Nominal Rate = (2)(5.14% C.00 per share..0%)(1 .82% 17.026325 + 0.64% 6. but the firm will have to pay flotation costs equal to 15 percent of this price. then what is the firm’s cost (their required rate of return) for a new issue of common stock? A. E.50%) = 11.91% 7. C.32% 20.0. Solve for I/YR = 5.3585. 20. but we need to find beta.73% 6.38) = 6.82% 6. If the firm issues new shares of stock it assumes that they will sell for the same price that investors are willing to pay today.0% After-Tax Rate = (11. Plug these values into the WACC equation and solve: WACC = [(0. D. we can use the SML equation.86% 16. A firm has a market-value balance sheet as indicated below.Solutions Page 17 of 42 Pages .00 $15.10 KP = $15/$150 = .15)] / [.10 KE = . D.4 percent.80% 13. it will pay a dividend of $15 per year.05 WE = $210/$300 = . The firm can meet their equity needs through additions to retained earnings and investors currently require a 16 percent rate of return on stock.16) = .00 Ke = [($1.00 Long-term Debt Preferred Stock Equity Total Liabilities and Equity $75.. Your company finances its projects with 50 percent debt. • • • The company can issue bonds at a yield to maturity of 6. the firm will only net $150 per share after accounting for related flotation expenses.00% 13.10)(1-.40) + (.00 12.15 / $19. If the firm issue preferred stock.15)] / [($23.00 $150. The cost of preferred stock is 7 percent.05)(.20% 19.60% 12.005 + . Old Exam Questions . what is the firm’s weighted average cost of capital (or the marginal costs of capital for the first dollar to be raised)? Balance Sheet at Market Value (In Millions) * A.00)(1. The company's common stock currently sells for $25 a share.20% 13.00)(1 . B.25 WP = $ 15/$300 = .20 .00 Total Assets $300.00 $50.70 KD = .00)(1.15)] + 0.00 $210. and 40 percent common stock. and although investors will be willing to pay $165 for each share of preferred.20% WD = $ 75/$300 = .15] = $23.16 WACC = (. C.55] + 0. 10 percent preferred stock.15 = 20.10) + (.015 + .25)(.00 $300. Given this data.P0 = [($1.. Current Assets Other Assets Fixed Assets $100. The firm assumes that it can issue debt at a before-tax cost of 10 percent and has a marginal tax rate of 40 percent.Cost of Capital .112 = 13.40% Answer: D 13.70)(.88% 18. E.15 = [$1. 8. Now assume that if the company issues additional stock.00)(1. Given this information. 10% preferred stock at a cost of preferred (KP) of 8 percent. E.50).50) + (. C.4% WACC = (. and that investors require a 12 percent rate of return.50 . Assume that a firm’s optimal capital structure consists of 30% debt at a before-tax cost of debt (KD) of 6 percent. Given this information.05) / $25] + . that the current price (Year 0) of the firm’s “constant growth” stock is $37.08 = 12. determine the cost of new external equity.48% 12. 12.00 Ke = ($1. and 60% stock.10) + (.08)] / [.62 / . * A.07)(.$2.05 = 13. B. that the dividend is expected to grow at a constant rate of 8 percent per year. Old Exam Questions .863% 9. C.00 a share (D0 = $2.0536 = .50 Net Price = $40. Based on this information.007 + .759% KS = [($2.34)(. it must pay its investment banker a flotation cost of $2.08 = 0. determine the firm’s expected dividend (D1) for the coming year.26% P0 = [($1.Cost of Capital . * Assume that a company just paid a $1.15% 12. The company’s tax rate is 34 percent.08] = $1. and no new stock will be issued.56 percent (assume retained earnings and ignore flotation costs).00) + 0. and that the firm’s weighted average cost of capital is equal to 9.Solutions Page 18 of 42 Pages .• • • The company's dividend is currently $2. E.50 per share dividend on its common stock (D0 = $1.26% 21.172% 8. Assume that the flotation cost on debt and preferred stock is zero.50.172% 20.00).134)(. determine the company’s weighted average cost of capital. that the firm’s tax rate is 40%.50)(1. that the firm retains 80 percent of its earnings.04 = $40.50%.015% 8.12 . and that its return on equity (ROE) is 12.0426 + 0. D. D.474% 7.50 per share. A.02112 + ..59% 12. B.064)(1-. Ke.08172 = 8.62 / $38.50 = $38.37% 12. and is expected to grow at a constant rate of 5 percent per year. Now assume that markets are in equilibrium (required rates are equal to expected rates).40) WACC = . Old Exam Questions . C. Based on this information.0956 = (0. and are currently priced at $1.53 per share next year (D1). You have been asked to calculate the appropriate cost of capital to be used to analyze these projects and have collected the following information: • • • • • • • • • • • • • Your firm’s targeted capital structure consists of 40 percent debt and 60 percent common equity.10)*($37.60) ^ KS = (. The company has bonds outstanding that have 10 years until maturity.1280 = 12.074.6 = 0.39.0.10) + (KS)*(0.0956 . The market risk premium is 6 percent. If the firm issues new shares of common stock.1280 .4.000. B. a maturity value of $1.10 $1.0. D. The company’s tax rate is 40 percent. and the firm will also have to pay flotation expense of 10%.30) + (0. $1.15 $1. The stock’s beta is 1.50) = $1. Your firm has estimated that it will spend $12 million on new capital budgeting projects during the coming year. determine the WACC (MCC) for the very first dollar to be raised. The current stock price (P0) is $45 per share.125)*(. The company’s ROE is 15% and its dividend payout rate is 40%. E.0108 + 0.05 22.* A.10 D1 = (0.08)*(0.50) + 0.20 $1. pay an annual coupon of $70 ($35 every six months). Each of the project’s to be taken on has the same degree of risk as the current projects of the firm. they will sell for $44 per share in the market.Cost of Capital .1280 = (D1 / $37. The risk-free rate is 4 percent.80) = 10% ^ KS = 0.4)*(0. Your firm expects to add $4 million to retained earnings over the coming year that can be used to support the $12 million in new projects.0080) / .00 WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) .05 $1. New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt.06)*(1-0.Solutions Page 19 of 42 Pages . The company expects to pay a dividend on its common stock of $1.80% = Ks ^ KS = (D1 / P0) + g g = RB = (. 80% .39.80% + (12. E.60% + 1.40%)(0.Cost of Capital . B.000.00.00 + 0.07% = 15.88% 23.99% C.53 / ($44.074.00)(1 . * Assume that an all equity firm has a return on assets (ROA) of 12.09 = 0. 9.86% (Not needed for this problem.15)(1 .8. 15.0.62% Determine YTM: N = 20.034 + 0.09 = 12.73% 15.84% 14. D.40) = 3.80%)(1/3) ROE = 12.09 = 12.44% + 7. FV = 1. calculate the firm’s ROE after the debt has been issued and equity has been repurchased. 8.80% to get EBIT of $256. g = (0.10) + 0. C. A. then working backwards from an ROA of 12.10% 15.0 * 2 = 6.00%)(1-. And that the firm makes the decision to replace ¼ of its equity with debt that has a before-tax cost of 8 percent (note: this will give a D/E ratio of (¼ / ¾) = 1/3 ). 9. PV = -1.4) = 12.00% .40% Alternatively.25% D.40) = 4.80% As discussed in class.47% The following is an illustration with some numbers that were “pulled from the air”: assets of $1.44% = 8.0.Solutions Page 20 of 42 Pages .6%)(0.* A.6% KS = 0.40) = 9% KS = $1.60) = 1.) Therefore.80% + 1. the remaining equity shareholders will benefit from both a leverage effect and a tax shelter effect: ROE = 12.40% Ke = $1. PMT = 35. 9.4. Assuming that the firm’s tax rate is 40 percent.06)(1.47% 14. Solve for I/YR = 3. after the issue and repurchase.00% = YTM After-tax KD = (6%)(1-.36% AT KD = (8. for very first dollar: WACC = (3.53 / $45.200.04 + (0. 8.88% E.40) + (12.00%)(1/3) + (8. Old Exam Questions .51% B.80 percent. 200.00 $1. The company pays out all of its earnings as dividends (retention rate of zero) and the company’s year-end dividend (D1) is forecasted to be $0.08)*(0. A. 10% preferred stock at a cost of preferred (KP) of 8 percent.200.00 256.30) + (0.82% 25.Cost of Capital .572 percent. and that the firm’s tax rate is 40%. Based on this information.00 $ 0.0.$ 24. D.00 0.80% 11.Assets/Income Without Debt Assets Debt (1/4) Equity $1.00 $ 300. The company will meet its equity requirements by issuing new common stock and they anticipate that total flotation costs will be equal to 20 percent of the amount issued.00 EBIT Interest (8%) EBT Taxes (40%) Net Income ROA ROE 24.10) + (KS)*(0. The company’s tax rate is 40 percent. The yield to maturity on the company’s debt is 6 percent.83% 12.4)*(0.49% 11. C.06)*(1-0. B. Old Exam Questions . * $ $ $ -$ $ With Debt $1.$ 92. 12.75 a share.200. E.00 . The company’s stock price is $25.60% 15.00 .00 256.40 153.09572 .09572 = (0. Also assume that the firm’s weighted average cost of capital is equal to 9.16% 11.00 102.80% 12.20 12.Solutions Page 21 of 42 Pages .60 $ 256.00 $ 900.0108 + 0. and 60% stock.0080) / .50% 12.6 = 0.00 $ 232.60) KS = (. The company expects that its dividend will grow at a constant rate of 6 percent a year.82% WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) .80 $ 139. Assume that an analyst has collected the following information about your company: • • • • • • • The company’s capital structure consists entirely of debt and equity and the debt/equity ratio is 2/3.1282 = 12. determine the firm’s cost of common stock (KS).47% Assume that a firm’s optimal capital structure consists of 30% debt at a before-tax cost of debt (KD) of 6 percent. 10.08 = 9. determine the firm’s cost of new equity.40)*(. E. C.75% WACC = (.75 / ($25. Given this information.4)*(. The price of the firm’s common stock is currently $45 per share. B. A.0975)*(. it expects to pay a dividend of $3. Given this information.08) + (.00 per share after adjusting for flotation costs.6) = 1. B. It also believes that if it sells new shares.15 / $45.75 / $20. * A.15 next year.00788) / . and assuming that the firm’s long-run sustainable growth rate is 6 percent. and its long-run sustainable growth is 6 percent. the market will be willing to pay $37. B.50 per share.Solutions Page 22 of 42 Pages .67) KP = (.01% 6. * Assume that a firm’s optimal capital structure consists of 25 percent debt.73% Debt / Value = 2 / (2 + 3) = 40% Equity / Value = 3 / (2 + 3) = 60% KD = 6% Ke = [$0.13)*(.87% 7.. C. 8 percent preferred. D.85% = 7.29% 26.06 = 9. D.85% 27.15% 6.4) + (. A. but that the firm would only net $33. where the firm will have sufficient retained earnings to meet its equity needs. and assuming that the firm has a weighted average cost of capital (WACC) of 10.85% 8.06)*(1-.14% 9. Given this data.44% + 5.25) + (KP)*(. and 67 percent equity. 11.08) = (.548 percent.0871) / (. E. 7..90 next year (D1).0105 .00 + . Assume that a firm expects that its common stock dividend will be $1..07)*(1-.56% KS = ($3.29% 7.98% 9.10548 = (.06 = 13% WACC = . determine the firm’s cost of preferred stock.10548 .27% 9.00) + .Cost of Capital .00% Old Exam Questions .Assume the company accounts for flotation costs by adjusting the cost of capital.52% 12. The firm’s before tax cost of debt is 7 percent and its tax rate is 40 percent.20)] + . determine the company’s WACC.06 = $0.00)*(1 . 11.14)*(0.000.000.000. determine the firm’s weighted average cost of capital (WACC).90 / $33.64% 29.Cost of Capital .000 of new debt.008 + 0. the company has decided to raise $4.Solutions Page 23 of 42 Pages .000. Preferred: 8% for the first $500.000.000 = 10% WS = $60.34% 11.04% 11. 6% for up to an additional $1.000 next year. C.60) WACC = 0.000 of new debt.08)*(1-0.084 = 0. and the before-tax costs of new financing are estimated to be: Debt: 4% for the first $500.28% 11.000 of this profit. preferred stock dividends are expected to account for $50.000.76% 28.4)*(0.000 = 60% WACC = (0.000 of debt at a before-tax cost of debt (KD) of 8 percent. B. * Assume that a firm’s optimal capital structure consists of $30. However.000. Old Exam Questions .000 of stock at a cost of stock (KS) of 14 percent.06 = 11.08)*(0. Assuming that the firm’s tax rate is 40%.000. D. $10.* C. 10. which is considered to be optimal. is shown below: Debt Preferred Stock Equity 30% 20% 50% In order to meet their expansion plans for next year.000 of new debt.000.94% 11. D. A. Net Income is expected to be $350.0144 + 0.76% Ke = ($1. Your company's current market-valued capital structure.30) + (0. and $60. The common stock dividend payout rate is 35% of the profit after the payment of preferred dividends.000 of preferred stock at a cost of preferred (KP) of 8 percent.000 of new preferred.000. 5% for up to an additional $1.64% WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS) WD = $30.000 / $100.000.24% 10. E.54% 10. The corporate tax rate is equal to 40%. E.000 = 30% WP = $10.000 / $100.1064 = 10.000 / $100.10) + (0.000.00) + 0.000. 40)(.63375% 6. Debt Debt Preferred Preferred RE Equity $500/$4.67% Old Exam Questions .000 of new common stock.6% There are several different ways to do this.000.45% 30.35) = $195. 16% for up to an additional $2.00 14.Cost of Capital . Given this information.875% 6. and 3.52500% 1. E.000 to be raised for the expansion.65% 8.00 8.500% $700/$4.24 = 6. determine the weighted average cost of capital for the entire $4.500% 6. D.31750% 9.45% 9.10 .00%.000% x x x x x x 2. Equity: 13% for retained earnings.805/$4. determine the firm’s before-tax cost of debt.500% $195/$4.40)(. D.05% 9. * A.25% RE = ($350. Given this information. and has a capital structure consisting of 40 percent debt and 60 percent equity.500% $300/$4.$50.125% 100.0%.40 3. 9.000 of new common stock.000 After-tax Costs of Debt: 2. One of them is below.85% 9.875% $1. E. * Assume that your firm has a weighted average cost of capital of 10. 6.000 of new preferred.4%.45125% WACC = 9.30000% 0.000)(1-.00000% 0. B.000 = 12.000 .000 = 4.00 13.40) = 0.000 = 7.00 9. B.000.667% 6. A.016 / 0. C.000 = 12.500% $500/$4.000 = 45.000 = 17. C.67500% 0.40) + (.000.333% WACC = 0.10 = (KD)(1-.9% for up to an additional $500.084) / (1-.0. 15% for up to an additional $2. 14% for up to the first $2. Also assume that the firm’s tax rate is 40 percent and that its cost of stock/equity (ignore flotation costs) is 14 percent.60) KD = (0.14)(. 3.000 of new common stock.00 = = = = = = 0.Solutions Page 24 of 42 Pages .000.125% 6. 31.95% 11. that this dividend will grow at a constant annual growth rate of 4%.83% 1.23% 1.872) / ($30.25% (you should now be able to determine the current price that investors should be willing to pay for this stock).04 = [($2. B.03% 1.1025 .35% 11. B. E.872 KS = [($1.04 = 10.1024)(.11% 8. D.04) = $1.80)(1.43% Investors: Old Exam Questions .80.15)] + 0.34% 32.75% 11.55% 11. Also assume that the firm will pay flotation expense of 15 percent to its investment bankers.34% D1 = ($1.63% 1. Investors will be willing to pay $150 per share. that the dividend just paid (D0) was $1.0. E.35)(. and that the marginal tax rate is 35%. E. A.00)(1-.04] = 11. 0. C.50) / (0. C. * Assume that your firm has a target capital structure of 30% debt and 70% common stock.50 / $34. Given this information.15% P0 = ($2. that the company’s before-tax cost of debt is 6%. and assuming that the firm’s equity needs can be financed from additions to retained earnings.04) = $40. Also assume that the current stock price (P0) is $30.50) / ($40. C.00 Ke = [$2.00)] + 0. * Assume that a firm can issue preferred stock with a par value of $100 and paying an annual preferred stock dividend of $12 per share.0117 + 0. D.24% WACC = (0. A.70) = 0.07168 = 0.Solutions Page 25 of 42 Pages .30) + (0.Cost of Capital .00) + 0. 8. B.72% 8.97% 8.06)(1-.00. 11. determine by how much the firm’s cost of this preferred stock exceeds the investors’ required rate of return on this preferred stock.35% 33. Given this information. Using the discounted cash flow (DCF) model.50 next year. and that this dividend is expected to grow at a constant rate of 4%.58% 9. but the firm will only net $130 per share (after paying $20 of flotation expense to its investment bankers). D. A. determine the firm’s weighted average cost of capital. and that investors have a required rate of return of 10. * Assume that your firm can issue new common stock that will pay a dividend (D1) of $2. determine the firm’s required rate of return on this newly issued equity.08338 = 8. 96% KP = $2 / ($20)(1 . D.000 Since equity = 32% of the capital budget.08 = 16.66% 12.10) + (16. then determine how large its capital budget may be before it will have to issue any new common stock (external equity).00)(1 . and that the marginal cost of capital for the last dollar to be raised is 12.00 = 0.75% = (KD)(.08) / $30.50 $5.000 = $6. C.0923 .26) + (1.20% Ke = [$2. 12. * A.00 = 0.75% = (KD)(1-.000.26% 11. that the company’s common stock trades at $30 a share. the capital budget can be: $2.00] + .47% MCC = 12.60) = $2. B.00)(1. Determine the firm’s before-tax cost of debt financing.Cost of Capital . while the flotation cost on preferred stock is 20 percent.50) MCC = 12.25 $6. 35.50%)(..000)(1 .08) / ($30. 10 percent preferred stock.75 percent. A.235%) Old Exam Questions .000 / .47%)(.00 / $130.86% 12.23% 34.00 / $150.0923 Difference = 0.250.000.40) + (12.15) + . that its current common stock dividend (D0) of $2 a share is expected to grow at a constant rate of 8 percent per year. E. B. and 60 percent of the net income will be paid out as dividends. $5.0800 Firm: KP = $12.75 million million million million million Addition to Retained Earnings = ($5.000.00 $6. C.50% KS = [($2.00)(1.25 million before external equity has to be issued.Solutions Page 26 of 42 Pages .0800 = 0. * Assume that your company has an optimal capital structure that consists of 32 percent equity and 68 percent debt. and 50 percent equity. and that the flotation cost of external equity is 15 percent of the dollar amount issued..0.32 = $6. If the company expects to report $5 million in net income this year. Also assume that the preferred stock pays an annual dividend of $2 and sells for $20 a share.56% 11. E. Assume that your company finances its operations with 40 percent debt.0123 = 1.25 $5.. D.35)(.20) = $2 / $16 = 12.KP = $12. that the firm will not have enough retained earnings to fully fund the equity portion of its capital budget. Now assume that the firm’s tax rate is 35 percent.08 = 15.25%) + (8. 08 New equity required rate of return = .235%) / .4)(. B.25/.40) = 1.Cost of Capital . determine the size of the firm’s optimal capital budget.75) = 1. C. and that the firm’s required rate of return (using CAPM) is 15 percent.9) New levered beta = 0. The company can issue bonds with a before-tax yield to maturity of 8 percent.8. * Assume that the beta of an all equity firm is 0.000 19% 16% 14% 13% 11% The company has a target capital structure that consists of 30 percent debt and 70 percent common equity.06)(1.26 = 12.875% Since the firm has a beta of 0.80% WACC = (8. next year’s dividend (D1) is forecasted to be $2.000 $ 300.375% 13.625% 13. KM must be equal to 16%: 15% = (. and if the tax rate is 40%.80)(.5)(1-.9. and the current stock price is $35 per share. $1.) A.9)(.06) + (. The company expects to add $350.265 / . E.125% 13.250..Solutions Page 27 of 42 Pages .000 $400.9.26 = 3.1. that the risk-free rate is 6 percent.16 ..5%. B. Given this information. D. The flotation costs associated with issuing new equity are 12.000 $375.5% of the market price. If the firm changes its capital structure to 25% debt and 75% equity.75)(1 .000 $325.000 $550. The company’s earnings are expected to continue to grow at 6 percent per year. 14. Your company is considering the following five independent projects: Project Cost IRR A B C D E $300.875% 37.000 to its retained earnings.08) = 16.000 Old Exam Questions . A.125% 13.45.275 + 12.56% 36.16 .25) + (16. then determine the firm’s new weighted average cost of capital (WACC).KD = (12. (You may assume that the beta for debt is zero..600 = 13. where the before-tax yield (cost) of debt is 8. and the firm faces a 40 percent tax rate.06)(0.75% .9 + (0.25% .06 + (. * A.055% Kd = 8% (given) Ke = [D1 / P0(1 .000.you may assume that the company accounts for flotation costs by adjusting the component cost of capital. An analyst has collected the following information regarding your company: • • • • • • • The company’s capital structure is 75 percent equity.0%)(.000 / .00] + 6.30) + (14.Cost of Capital .625.* C.625.70) = 1. B.44% + 9. D.5 percent of the amount issued -..80% = 11.125)] + 6. D.736% 9.44% + 9. Its investment bankers anticipate that the total flotation cost will equal 12.000: WACC = (4.8%)(.0%)(. the firm should take on Projects A-D and the size of the optimal capital budget should be $1.0%)(1-. 25 percent debt.000 KD = (8.0% = 13. 10.30) + (13.00)(1 . 38.10% = 10. E. E.0% Firm will switch from KS to Ke when the capital budget hits $350.70 = $500.000 $ 850.0% = 14.70) = 1. Given this information. The company’s dividend next year is forecasted to be $1.Solutions Page 28 of 42 Pages .349% 9. The company’s tax rate is 40 percent.627% 11.950.000: WACC = (4.F)] + g Old Exam Questions .4) = 4.25 a share. C.45 / ($35.000 $1. $1.914% 10. determine what the company’s WACC will be when it is forced to issue new shares of common stock.24% Therefore.8% KS = [$2.0% Ke = [$2. The before-tax yield to maturity on the company’s bonds is 8 percent and the bonds are selling at par value. The company anticipates that it will need to raise new common stock this year.45 / $35. The company expects that its dividend will grow at a constant rate of 6 percent a year.8%)(.000 Below $500. The company’s stock price is $20.54% Above $500. PV = -934. Solve for I/YR = (4. Your firm has estimated that it will spend $10 million on new capital budgeting projects during the coming year and has collected the following information: • • • • • • • • • • • • • • Your firm’s targeted capital structure consists of 40 percent debt.25 / $20(1 .055% 39.14%) = 1.75)(13. * A.40) = 5. New preferred stock (at least $2 million) can be issued at a price of $100 per share.2% + 9.T) + WeKe WACC = (0. This preferred stock will pay an annual dividend of $9. and a current price of $934.4% Old Exam Questions .5%.00%)(0. The current stock price (P0) is $30 per share.000.000)*(. but flotation costs will be 20 percent.504% New Equity = ($10.50) . PMT = 40.000 Find rD: N = 20. they will sell for $30 per share. The company’s tax rate is 40 percent.620% 12.0 million to retained earnings over the coming year that can be used to support the $10 million in new projects. The company’s ROE is 20% and its dividend payout rate is 70%.76 per share next year (D1).Ke = [$1. B.25)(8. The market risk premium is 8 percent.14% WACC = WdKd(1 . Your firm expects to add $3.125)] + 0. 11.736% 10. The company expects to pay a dividend on its common stock of $2. If the firm issues new shares of common stock.0. a semi-annual coupon of $40.855% = 11.000. The risk-free rate is 4 percent.6) + (0.0% After-tax rD = (9%)(1-.062% 12.000 = $2.96. 10 percent preferred. Each of the project’s to be taken on has the same degree of risk as the current projects of the firm.$3. Given this information. a face value of $1. The stock’s beta is 1. but the firm will have to pay flotation expense of 12.Solutions Page 29 of 42 Pages . C.36.4.60 per share.000.000. The company has corporate bonds outstanding that have 10 years until maturity.50)*(2) = 9. determine the weighted average (marginal) cost of capital of the very last dollar to be raised. and 50 percent common equity. New debt (at least $7 million) can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt.06 = 13. FV = 1. D.Cost of Capital . E.178% 11.000. 4%)(0.76 / $30.76 / ($30. for the very last dollar raised WACC = (5.00)*(1-. determine what the firm’s new weighted average cost of capital will be if it changes to a capital structure of 50 percent debt and 50 percent equity (a debt/equity ratio of 0. g = (0.20% Alternatively.51%)(0.00 = 12.0)*(1 .40) + (12.476923077 = 1. 8.40)) = 1.30% Determine current levered beta: 10.20) / (1 + (0.70% 7.50).62% 40. B.06 = 0.2% + 8.50) = 2.08)(1.092 + 0.50/0.0% = 4.51% Therefore. Given this information.70) = 6% rS = $2.06 = 16.0. that its tax rate is 40 percent.0%) / 5.16% + 1.0%)*(βL) βL = (10.00 + 0.923076923 Relever beta at new capital structure: βL = (0.60 / ($100.10% 6. * Assume that a firm’s current capital structure consists of 1/3 debt and 2/3 common stock (a debt/equity ratio of ½ or 0. E.923076923)*(1 + (1.125) + 0.50% 9.26% = 11.2% re = $2.0% = 1. D.48 Old Exam Questions .Solutions Page 30 of 42 Pages .90% 8. Also assume that the risk-free rate is 4 percent and that the market risk premium is 5 percent (you should now be able to calculate the firm’s levered beta).00)(1 .50 or 1.40)) = 0.0) A.10) + (16.Cost of Capital . C. and that its cost of common stock is 10 percent.50)(1-.04 + (0.60 / $80.4.0%)(0.20 Unlever beta: βU = (1.Find rP: rP = $9.0.0% Find rS and re: rS = 0.4) = 15.06 = 15. Assume that the firm’s before-tax cost of debt is 6 percent.0% + (5.20) = $9..20)(1 .0% . • The current stock price (P0) is $28.4)(20%) + (. Old Exam Questions .50% 41.000. and issued $40.48% 10. determine the weighted average cost of capital (WACC) for this project.114)(. 11.15)(80%) = . • The company’s tax rate is 40 percent. • The market risk premium is 6 percent.12 = 12.20 per share next year (D1).057 = 7. E. • If the firm issues new shares of common stock. D.4)(.48) = 11.Determine new rS = 4.000 of equity at a cost of equity of 15%.96% 12.40% Calculate new WACC: WACC = (rD)(1-T)(rD) + (rS)(rS) WACC = (.95 per share.50 per share (a slight discount from the current price). • The company’s ROE is 20% and its dividend payout rate is 70%. and the firm will have to pay flotation expense of 10.Cost of Capital . • The stock’s beta is 1.50) + (. Assume that your firm has estimated that it will spend $20 million on new capital budgeting projects during the coming year and that you have been asked to calculate the appropriate cost of capital to be used to analyze these projects.96% 42.0 million to retained earnings over the coming year that can be used to support the $20 million in new projects.6. * Assume that a firm takes on a project that requires an initial investment in Year 0 of $50.000 of debt at a before-tax cost of debt of 8%.75). C.0% ($2.0% + (5.08)(1-. • The risk-free rate is 4 percent.0%)*(1. • The company has corporate bonds outstanding with an 8 percent annual coupon that are trading at par.0096 + .000 by issuing $10. B.Solutions Page 31 of 42 Pages . they will sell for $27.06)(1-. Also assume that the firm raised the $50. • Your firm expects to add $5.018 + 0. A. and assuming that the tax rate is 40%. Given this information.50) = 0. You have collected the following information: • Your firm’s targeted capital structure consists of 40 percent debt and 60 percent common equity.44% 11.98% 12.92% WACC = (. • New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt. • Each of the projects to be taken on has the same degree of risk as the current projects of the firm. • The company expects to pay a dividend on its common stock of $2. E. as demonstrated in class.94% 10. g = (0.. determine what the new cost of equity must be.) A.000)*(.8%)(0. we would have the following: After-tax rD = (8%)(1-.000: $12.94% = 10. and that the before-tax cost of debt remains constant at 8 percent.32% 11.000. [Given this information.000 by stockholders who required a 15 percent rate of return.40) + (14.Cost of Capital .46% Old Exam Questions .86% 43.000. * A.000. C.04 + (0.000.6% Alternatively. and assuming that the WACC remains constant at 10. you should be able to determine that the weighted average cost of capital (WACC) for the firm is 10.48% 10.20 / $28. [Based on this information.92 percent. C.000 Equity = ($20.92 percent.06)(1.000.6) = 13.48% 13.40% 11.92% + 8.20 / ($27. B.40) = $8.000.076 + 0.000 Since the firm only expects to add $5.95 + 0.000th) to be raised. you should be able to calculate the enterprise value and/or market value added (MVP or NPV).000)*(.06 = 13. and $18.40% Breakdown: Debt = ($20.] Now. the $20. Therefore.Solutions Page 32 of 42 Pages .000 and EBIT of $6. and that its operations will produce sales of $40.6% re = $2.000.000 to its retained earnings account.06 = 0.000. D.8% rS = 0. and knowing that the tax rate is 40 percent. D.000.60) = $12.20)(1 . B.50)(1-.000.06 = 0.40) = 4. you should now be able to calculate the free cash flow and/or the economic value added for all future years.44% 15. (Hint: the debt/value and equity/value ratios will change but the WACC will remain constant.000. 12.60) = 1.9%)(0.70) = 6% rS = $2.] Now assume that for all future years the firm expects to make no additional investments in assets.86% 11. and from this and the WACC previously determined.089 + 0. that depreciation is zero. 12.06 = 14. Assume that your firm has just opened for business and that it was originally funded with investor-supplied capital equal to $30.10) + 0.Given this information.000 by creditors who required an 8 percent before-tax rate of return. the equity portion for the very last dollar to be raised must come from newly issued equity.90% WACC = (4.0.000.e. determine what the WACC/MCC will be for the very last dollar (i. 000.967. Interest = ($12.967.08)*(1-.7472%) / 0.033 MV of Equity = $32.033 MV of Equity = $18.024.* E.000 -$ 960.000 -$2.000.6) = 1.60% WACC = 10.033 = 36.92% .033 Debt/Value = $12.08) = $960.600.967.Cost of Capital . EVA = $3.0% = 10.92% .364) + (rS)*(.000.000.033 = 14.967.000 EBIT Interest EBT Taxes Net Income $6.000.967.000 $5.40% Equity / Value = $20.967.967.033 .00)*(.1.000.42% Alternatively.00)*(1-.024.4) + (.967.636 = 14.000 + $2.967.000 / .08)*(1-.040.033 = 63.Solutions Page 33 of 42 Pages .0000 / .636) rS = (10.4)*(.($30.000.15)*(.033 = 63.7472%) / 0.000.600.000.4)*(.967.000.033 = 36.364) + (rS)*(.000 MVA = NPV = $324.00 Enterprise Value = $3.967.000)*(0.000.000 / $32.003 = $32.422641509% = 14.000 .024.4)*(. 14.000 / $20.033 Enterprise Value = $12.92% + 9.003 = $20.000 + $20.016.967.1.92 percent NOPAT = FCF = ($6.967.42% Old Exam Questions .000 = $20.000.1092 = $2.92% = (.033 = $3.000 $3.92% = (.000 / rS rS = $3.1092) = $324.033 / $32.$12.600.000 / $32.636) rS = (10.40% Equity / Value = $20.08)*(1-.60% WACC = 10.42% WACC = (.4) = $3.967.033 Debt/Value = $12.42% Alternatively.000 MV Equity = $20.636 = 14.967.1092 = $32.967.033 / $32. The company’s ROE is 20% and its dividend payout rate is 70%. a face value of $1.86% 45. Each of the project’s to be taken on has the same degree of risk as the current projects of the firm.000.$5) + 6% = $1. issue new common stock.07% 11. The stock’s beta is 1. therefore. E.0 million to retained earnings over the coming year that can be used to support the $10 million in new projects. Your firm has estimated that it will spend $10 million on new capital budgeting projects during the coming year and has collected the following information: • • • • • • • • • • • • • • Your firm’s targeted capital structure consists of 40 percent debt.96% 12. New debt (at least $7 million) can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt. The new stock has an estimated flotation cost of $5 per share. Given this information. 10 percent preferred.Solutions Page 34 of 42 Pages . Determine the company's cost of new equity capital. not a percent of the stock’s price: re = D1/(P0 .00). B. 9.67% 8. C. New preferred stock (at least $2 million) can be issued at a price of $100 per share. A. C.4. but flotation costs will be 20 percent.33% 12. Your firm expects to add $3. * Your company’s stock currently has a price of $40 per share and is expected to pay a year-end dividend of $1. and a current price of $934. This preferred stock will pay an annual dividend of $9. D. D. determine the weighted average (marginal) cost of capital of the very first dollar to be raised. The company has insufficient retained earnings to fund capital projects and must.86% In this case. and 50 percent common equity. The dividend is expected to grow at a constant rate of 6 percent per year. a semi-annual coupon of $40.5%.59% 9.00 per share (D1 = $1.00/($40 .44. 10.76 per share next year (D1).44% Old Exam Questions .13% 9.Cost of Capital . The market risk premium is 8 percent. * A. If the firm issues new shares of common stock. The risk-free rate is 4 percent. B.96. they will sell for $30 per share.F) + g = $1. The company expects to pay a dividend on its common stock of $2. but the firm will have to pay flotation expense of 12.40% 8. The company’s tax rate is 40 percent.00/$35 + 6% = 2. The company has corporate bonds outstanding that have 10 years until maturity. The current stock price (P0) is $30 per share. F is in dollar form.86% + 6% = 8.60 per share. 000 But not needed for the very first dollar.20% Alternatively.7625% 8.E. Also assume that the risk-free rate is 4 percent and that the market risk premium is 5 percent (you should now be able to calculate the firm’s levered beta).4800% 7.50)*(2) = 9.000)*(.$3.000.76 / $30.10) + (15. FV = 1.Cost of Capital . PV = -934.06 = 16.70% New Equity = ($10. for the very first dollar raised WACC = (5.51% Therefore. that its tax rate is 40 percent.76 / ($30.0% Find rS and re: rS = 0.06 = 15.4) = 15.50) = 2. 6. B.40) + (12.00)(1 . g = (0. E.2% re = $2.000.00)*(1-.16% + 1.50) .4% Find rP: rP = $9.092 + 0.36.000.1900% 7.04 + (0.0%)(0. * Assume that a firm’s current capital structure consists of 50 percent debt and 50 percent common stock (a debt/equity ratio of 1.08)(1. Given this information.6% = 10.06 = 0.125) + 0.2% + 7.9075% 6.0% After-tax rD = (9%)(1-. since RE will be used for equity.000. Solve for I/YR = (4.4%)(0. determine what the firm’s new weighted average cost of capital will be if it changes to a capital structure of 75 percent debt and 25 percent equity.3350% Determine current levered beta: Old Exam Questions .0. PMT = 40.2%)(0.40) = 5. and that its cost of common stock is 11 percent.70) = 6% rS = $2.00 = 12.0.60 / ($100.96% 46. Assume that the firm’s before-tax cost of debt is 6 percent. Find rD: N = 20.60 / $80. A.00).20) = $9.20)(1 . C. D.000 = $2.00 + 0.Solutions Page 35 of 42 Pages . 11. (HINT: you should now be able to calculate its WACC and back out its levered and unlevered beta. the return on the market is 12 percent.040625 = 6.0)*(1 . and that a firm has a debt/value ratio of 1/3.5.40)) = 0.1625)(.06)(1-.50 New Debt/Equity Ratio = (2/3) / (1/3) = 2.75) + (.00)(1-.0% = 5.4.46% Original Debt/Equity Ratio = (1/3) / (2/3) = 0.098901099 βL2 = [1. D.0)(1-.0% + (12.5.25) = 0.Solutions Page 36 of 42 Pages .0%)*(βL) βL = (11.7625% 47.40 Unlever beta: βU = (1.Cost of Capital . a before-tax cost of debt of 8 percent.45) = 16.0%)(2.19% 22.0% . B.00)*(βL1) βL1 = (15.0%) / 7.027 + 0.0%) / 5.92% 22.40)] = 1.4)(.0% + (12. and a tax rate of 40 percent.098901099] * [1 + (2.0%) = 1.0%)*(2.875 Relever beta at new capital structure: βL = (0.25% Calculate new WACC: WACC = (rD)(1-T)(rD) + (rS)(rS) WACC = (. A. Using the Hamada equations to relever beta.45 Determine new rS = 4.50)(1-.0% = 4.40) / (1 + (1.92% Old Exam Questions . E.0 rS = 15. determine what the firm’s new cost of equity will be.0% + (5. a cost of equity of 15 percent.40)] = 2..0% = 1.) Now assume that the firm intends to double its debt and use the proceeds to buy back its stock (the debt/value and equity/value ratios will each now be 2/3 and 1/3 respectively). an equity/value ratio of 2/3.00% 22.0% .428571429 / 1.428571429 βU = 1. 23.0% .0% .417582418) = 21.11. * Assume that the risk-free rate is 5 percent.40)) = 2.0% + (5.5.30 = 1. C.428571429 / [1 + (0.417582418 New rS = 5.73% 21.875)*(1 + (3. 054 = 0.95 + 0. • Your firm expects to add $5. and the firm will have to pay flotation expense of 10. E.73) = 5.054 = 0.30% (not needed) Old Exam Questions . they will sell for $27.076 + 0. • The company has corporate bonds outstanding with an 9 percent annual coupon that are trading at par.45% 9.20 / $28. * A.000 to its retained earnings account.0% ($2. • Each of the projects to be taken on has the same degree of risk as the current projects of the firm. You have collected the following information: • Your firm’s targeted capital structure consists of 40 percent debt and 60 percent common equity.054 = 14.96% 9. • New debt can be issued as a private placement (no flotation expense) and will have the same level of risk as the firm’s current debt. B. • The company expects to pay a dividend on its common stock of $2. D.0% Alternatively.50)(1-.Solutions Page 37 of 42 Pages . the equity portion for the very first dollar to be raised will come from retained earnings.62% Since the firm expects to add $5. • The risk-free rate is 4 percent.95 per share. Assume that your firm has estimated that it will spend $20 million on new capital budgeting projects during the coming year and that you have been asked to calculate the appropriate cost of capital to be used to analyze these projects.20 / ($27.4% rS = 0.0% re = $2.75).054 = 13.089 + 0.50 per share (a slight discount from the current price).48.20 per share next year (D1).5) = 13.04 + (0.0. • The stock’s beta is 1. • The company’s tax rate is 40 percent.20)(1 .06)(1.28% 9. 9.40) = 5. • If the firm issues new shares of common stock.4% rS = $2.Cost of Capital . • The current stock price (P0) is $28. • The company’s ROE is 20% and its dividend payout rate is 73%.10) + 0.000.0 million to retained earnings over the coming year that can be used to support the $20 million in new projects. g = (0. C. Given this information. Therefore.79% 9.5. we would have the following: After-tax rD = (6%)(1-. • The market risk premium is 6 percent. determine what the WACC/MCC will be for the very first dollar to be raised. but that flotation costs would be equal to $4.50 = ($1.Cost of Capital .8% = 9. which will grow at the firm’s constant.06) = $1. Given this information.Solutions Page 38 of 42 Pages . the tax rate is 40 percent.16% + 7. Assume that a firm’s targeted capital structure consists of 35 percent debt.0175 percent.00 = 6.0%)(0.50g + $26.50 = $22.WACC = (5. B. Also assume that the current yield on the firm’s debt is 9 percent.0% D1 = ($1.23% P0 = (D0)*(1+g) / (rS .50.06 = 13.83% 16.] The company’s investment bankers have told them that if they issue new stock. determine the firm’s cost of newly issued equity (re).00) + 0. * Assume that investors in the stock of Company A have a required rate of return of 12 percent.00 re = (D1 / PN) + g re = ($1.23% 50.50)*(. A.g) $26.12 .68 = $28.96% 49.50g ($3.4%)(0. and the firm’s weighted average cost of capital (WACC) is 11.50.53% 14.12 .60) = 2. Old Exam Questions . [HINT: you should now be able to determine the long-run sustainable growth rate.50 per share. and 50 percent common stock.50)*(1+g) / (.50g) $1. The company has just paid a dividend of $1.$1.50)*(1. Given this information.50) = ($1.50 per share.18 .g) ($26. long-run sustainable growth rate) and the stock has a current price of $26. D.59 PN = $26.50 + $1. E.50 (D0 = $1.50g = $1.18 . they could issue it at the current market price of $26.00g ⇒ g = $1.68% 15. 17. the cost of stock is 15 percent.g) = ($1. 15 percent preferred stock.50 .50)*(1+g) Multiplying through: $3.38% 13.59 / $22.40) + (13.68 / $28. determine the firm’s after-tax cost of preferred stock (rP).$26.$4. C. $5. Given this information.50g ($3. B.g) $27.50 = 8. which will grow at the firm’s constant.15)*(. E. * Assume that investors in the stock of Company A have a required rate of return of 14 percent.83% 16.28 / $28. 9. determine the firm’s cost of newly issued equity (re).35% 9. [HINT: you should now be able to determine the long-run sustainable growth rate.62 PN = $27.28 = $28.Cost of Capital . D.$1.00g = $1. C. D.00g) $2.00)*(.08) = $1.50 + $1.50) rP = (0.] The company’s investment bankers have told them that if they issue new stock.110175 .78 .35) + (rP)*(.85% 51.53% 14.Solutions Page 39 of 42 Pages .110175 = (.00 = ($1.0.68% 15.50)*(1+g) / (.075) / .35% WACC = .00.23% P0 = (D0)*(1+g) / (rS .00 per share.09)*(1-.50.50 per share.35% 10.08 = 15.50) = ($1.85% 10.4)*(. E.50) + 0.0% D1 = ($1.15) + (. A.14 . C. but that flotation costs would be equal to $5.50g + $27.14 .0189 .$27. The company has just paid a dividend of $1.78 .50)*(1.85% 11.50g ⇒ g = $2.62 / $21.* A.15 = 10. B. they could issue it at the current market price of $27.0.g) = ($1.50 = $21.53% Old Exam Questions .38% 13.50 re = (D1 / PN) + g re = ($1.50 (D0 = $1. long-run sustainable growth rate) and the stock has a current price of $27.00 . 17.g) ($27.50)*(1+g) Multiplying through: $3. 52. A.15) + (. D. 15 percent preferred stock.000.500. The company’s forecasted capital budget for the coming year is $12.0.e. Given this information.50 percent of the amount issued (or price per share) -.85% 11. C. but that it will also need to raise new common stock over the year.50) rP = (0.000. Also assume that the current yield on the firm’s debt is 9 percent.35% 9. B. The company’s stock price is $20. the tax rate is 40 percent.35) + (rP)*(.075) / .23% rd = 7% (given) AT rD = (7%)*(1-.09)*(1-.2% rS = [D1 / P0] + g Old Exam Questions . and 50 percent common stock.109425 . E. determine what the company’s average cost of capital will be for the entire $12.25 a share. The company anticipates that it will add $4.4) = 4.Solutions Page 40 of 42 Pages . C.000 to its retained earnings account over the coming year. The company expects that its dividend will grow at a constant rate of 6 percent a year.85% 10.9425 percent. E. 9. Assume that you have collected the following information regarding your company: • • • • • • • • The company’s capital structure is 60 percent equity.you may assume that the company accounts for flotation costs by adjusting the component cost of capital (i.35% WACC = . * A. and the firm’s weighted average cost of capital (WACC) is 10.88% 9.15 = 10.33% 8. 10.35% 10. determine the firm’s after-tax cost of preferred stock (rP).000 to be raised.68% 9. The before-tax yield to maturity on the company’s bonds is 7 percent and the bonds are selling at par value – you may ignore flotation costs. The company’s tax rate is 40 percent.0. 40 percent debt. Its investment bankers anticipate that the total flotation cost for new common stock will equal 12.4)*(.109425 = (. * Assume that a firm’s targeted capital structure consists of 35 percent debt.35% 53.Cost of Capital . B. D..15)*(. Given this information. The company’s dividend next year is forecasted to be $1. it determines a price that it will net and then uses a DCF approach to determine re).78% 10. the cost of stock is 15 percent.0189 . The company’s forecasted capital budget for the coming year is $15.F)] + g re = [$1.06 = 12.000 / $12.000.Solutions Page 41 of 42 Pages .59375% + 2. but that it will also need to raise new common stock over the year.000. E.000 Weights of Total to be Raised: Debt = $4.500.000 = 22. Its investment bankers anticipate that the total flotation cost for new common stock will equal 12. B.23% 54.0.000 Retained Earnings = $4.800.225) Average Cost = 1.rS = [$1.000 / $12. The company anticipates that it will add $4..e. The company’s dividend next year is forecasted to be $1. The company’s stock price is $20. D.000.125)] + 0. * A.68% 9.40) + (12.40) = $4.000. determine what the company’s average cost of capital will be for the entire $12.000 = 40% Retained Earnings = $4.500. C.Cost of Capital .23% Old Exam Questions .800.60) .000 / $12. Given this information.50% Average Cost = (4.14% Amount to be Raised: Debt = ($12.14%)*(.27025% = 9.you may assume that the company accounts for flotation costs by adjusting the component cost of capital (i.000.25%)*(.33% 8.000 = 37. 10.000 = $2.2%)*(.50% New Equity = $2.375) + (13.700.68% + 4.700. 40 percent debt.000.000 (Given) New Equity = ($12.000)*(. it determines a price that it will net and then uses a DCF approach to determine re).000)*(.000 to be raised.500.25 / $20] + 0.50 percent of the amount issued (or price per share) -.25% re = [D1 / P0(1 .25 a share. The company expects that its dividend will grow at a constant rate of 6 percent a year.500.06 = 13.25 / $20(1 .000.000 to its retained earnings account over the coming year.$4.88% 9. The company’s tax rate is 40 percent.9565% = 9. Assume that you have collected the following information regarding your company: • • • • • • • • The company’s capital structure is 60 percent equity.78% 10. The before-tax yield to maturity on the company’s bonds is 9 percent and the bonds are selling at par value – you may ignore flotation costs. 25 / $20(1 .000 = 40% Retained Earnings = $4.40) + (12.60) .00% Average Cost = (5.00% New Equity = $4.78% Old Exam Questions .30) + (13.Solutions Page 42 of 42 Pages .000)*(.000.500.337% = 9.000 = $4.000 / $15.500.rd = 9% (given) AT rD = (9%)*(1-.25% re = [D1 / P0(1 .4%)*(.000 Weights of Total to be Raised: Debt = $6.25%)*(.14%)*(.40) = $6.000 = 30.675% + 3.500.30) Average Cost = 2.06 = 13.F)] + g re = [$1.000.000 Retained Earnings = $4.000.000)*(.000.Cost of Capital .125)] + 0.0.000 = 30.000.06 = 12.$4.942% = 9.000 / $15.14% Amount to be Raised: Debt = ($15.500.000.16% + 3.25 / $20] + 0.000 / $15.000.000 (Given) New Equity = ($15.500.4% rS = [D1 / P0] + g rS = [$1.4) = 5.