11-6

The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at
7 percent per year in the future. Carpetto's common stock sells for $23 per share, its last dividend was
$2.00, and it will pay a dividend of $2.14 at the end of the current year. THIS IS A FOUR PART QUESTION,
NOT MULTIPLE CHOICE.
(a) Using the DCF approach, what is the cost of common equity?

Cost of common equity Ke = D1/P0 +g

D1 = 2.00 (1 + 0.07) = 2.14
Ke = 2.14/23 + 0.07
= 16.30%

(b) If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13
percent, what will be the firm's cost of common equity using the CAPM approach?

Required rate of return = Risk free rate + beta x Market risk premium
= 9% + 1.6 (13% - 9%)
= 15.4%

(c) If the firm's bonds earn a return of 12 percent, what will rs be based on the bond-yield-plus-risk-
premium approach, using the midpoint of the risk premium range?

Rs= Bond yield + Risk premium

=12%+4%
=16%

(d) Assuming you have equal confidence in the inputs used for the three approaches, what is your
estimate of Carpetto's cost of common equity?

It is difficult to estimate beta and also growth rate has to be assumed to be constant. Thus bond-yield
plus risk premium approach is appropriate to calculate cost of equity.
Cost of common equity Ke = D1/P0 +g
=(2.14)/23+7%
=16.3%

11-8

Cost of debt = 12%

After tax cost of debt = 12% (1 - 40%) = 7.2%

Cost of equity = D1/P0 + g

D0 = 2

D1 = D0 (1 + g)

= 2 (1 + 0.07)

= 2.14

Cost of equity = 2.14/22.50 + 0.07

= 0.095 + 0.07

= 0.165 or 16.5%

WACC = Weight of debt x cost of debt + weight of equity x cost of equity

= 0.4 x 7.2% + 0.6 x 16.5%

= 2.88% + 9.9%

= 12.78%

11-9

The Patrick Companys cost of common equity is 16%, its before-tax of debt is 13%, and its
marginal tax rate is 40%. The stock sells at book value. Using the following balance sheet,
calculate Patricks WACC.

Problem 10-9

Capital Sources Amount Capital Structure Weight

Long-term debt $1,152 40.0%
Common Equity 1,728 60.0
$2,880 100.0%

WACC = wdrd(1 T) + wcrs = 0.4(0.13)(0.6) + 0.6(0.16)

= 0.0312 + 0.0960 = 12.72%.

11-11

20%-ANSWER
11-14

11.94%-ANSWER

11-16

a.

2004 2000

EPS = 6.5 4.42

DPS (40%) = 2.6 1.768

Calculation of growth rate:

PV = -1.768

FV = 2.6

NPER = 5

Growth rate =?

Solve for rate

Rate = 8%

b.

D0 = 2.60
D1 = 2.60 (1 + 0.08) = 2.808

c.

Cost of retained earnings rs = D1/ P0 + g

rs = (2.808/36) + 0.08

rs = 0.158 or 15.8%

11-18

a) cost of debt: rd * (1 - tax) = 0.09 * (1 - 0.30) = 0.063, or 6.3%<after tax rate of debt (pre-tax rate is
9%)

cost of preferred stock: (valued like a perpetuity) : div/r = price, rearrange: div/price = r, 6/50 =
0.12, or 12%

use Gordon growth model and solve for r: Price at t=0: D1/(r-g), rearrange: D1/price = (r-g):
4.25/40 = 0.10625<=(r-g)...0.10625 - g = r, 0.10625 - 0.05 = 0.05625<r

b) WACC = wd(rd*(1-tx)) + wp(rp) + we(re), where w= weight, r= rate

WACC = 0.15(0.063) + 0.10(0.12) + 0.75(0.05625) = 0.06364, or (round to) 6.36%

11-20
a. First find g the earnings growth rate. g is the compound annual growth rate in EPS. The EPS has
grown from 3.90 to 7.80 in 9 years ( from 1993 to 2002). Using the compound interest formula, you
get
7.80=3.90*(1+r/100)^9. Solving for r gives r=8%. ( You can also use the rule of 72 the EPS has
doubled in 9 years, so rate is 72/9=8%)
The expected dividend (D1) is 55% of 7.80=4.29
Cost of Common Equity = D1/Po+g = (4.29/65)+.08=14.6%
After Tax cost of debt is 9*(1-0.4)=5.4%

b. The WACC = Proportion of debt X cost of debt + Proportion of equity X cost of equity
WACC = (104,000,000/260,000,000 ) X 5.4% + (156,000,000/260,000,000) X 14.6%
WACC= 10.92%