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CHAPTER 11: THE COST OF CAPITAL

Instructor’s Manual Problem Set


Solutions can be found in the accompanying Excel files. Note that if you wish to see all of the formulas at
once, you may use the CTRL+` (Control plus grave accent) shortcut key to toggle them on or off.

1. The Claustrophobic Solution, Inc., a residential window and door manufacturer, has the
following historical record of earnings per share (EPS) from 2013 to 2017:
2017 2016 2015 2014 2013
EPS $1.10 $1.05 $1.00 $0.95 $0.90

The company’s payout ratio has been 60% over the last five years and the last quoted price of
the firm’s stock was $10. Flotation costs for new equity will be 7%. The company has
30,000,000 common shares outstanding and a debt-equity ratio of 0.50.
a) If dividends are expected to grow at the same arithmetic average growth rate of the last five years,
what is the dividend payment in 2018?
b) Calculate the firm’s cost of retained earnings and the cost of new common equity using the constant
growth dividend discount model.
c) Calculate the break-point associated with retained earnings.
d) If the Claustrophobic Solution’s after-tax cost of debt is 9%, what is the WACC with retained
earnings? With new common equity?
e) Assuming that the cost of debt is constant, create a marginal cost of capital (MCC) schedule. Be sure
to use a Scatter chart and make it a step function.

2. Black Diamond, Inc., a manufacturer of carbon and graphite products for the aerospace and
transportation industries, is considering several funding alternatives for an investment project.
To finance the project, the company can sell 1,000 15-year bonds with a $1,000 face value, 7%
coupon rate. The bonds require an average discount of $50 per bond and flotation costs of $40
per bond when being sold. The company can also sell 5,000 shares of preferred stock that will
pay a $2 dividend per share at a price of $40 per share. The cost of issuing and selling preferred
stocks is expected to be $5 per share. To calculate the cost of common stock, the company uses
the dividend discount model. The firm just paid a dividend of $3 per common share. The
company expects this dividend to grow at a constant rate of 3% per year indefinitely. The
flotation costs for issuing new common shares are 7%. The company plans to sell 10,000 shares
at a price of $50 per share. The company’s tax rate is 40%.
a) Calculate the company’s after-tax cost of long-term debt.
b) Calculate the Company’s cost of preferred equity.
c) Calculate the company’s cost of common equity.
d) Calculate the company’s weighted average cost of capital.
e) What is the company’s weighted average cost of capital without flotation costs?

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66 Chapter 11: The Cost of Capital
Instructor’s Manual Problem Set

3. Solid Structures, Inc., a manufacturer of steel wire reinforcements and pre-stressed concrete
strands for the concrete construction industry, wants to determine its WACC. Today, 1/1/2018,
the firm issued 7,000 bonds that will mature in 1/1/2038 with $1,000 face value. These bonds
will pay a 9% coupon rate semiannually and are currently selling for $950. The firm has
100,000 preferred shares of stock outstanding with a book value of $40, but currently selling for
$50 per share. The most recent preferred and common dividends were $3.50 and $2.50 per
share, respectively. The firm’s EPS five years ago was $8.00 and it expects to increase its next
dividend payment by the implied 5-year earnings per share growth rate. Flotation costs on debt
and preferred equity are both 3%, but 7% in the case of common stocks. The common stock is
selling today for $25 and the firm’s tax rate and payout ratio are 40% and 25%, respectively.
The firm has 200,000 shares of common stock outstanding with the same book value as that of
its preferred stock.
a) Calculate the book value and market value weights for each source of capital.
b) Calculate the component costs of capital (i.e., debt, preferred equity, retained earnings, and new
common equity).
c) Determine the weighted average costs of capital using both the market and the book value weights.

4. Suppose the firm in the previous problem can raise new funds in the capital markets under the
following conditions:
Source Range After-tax Cost
Retained Earnings Up to 500,000 Solution Problem #3
Common Equity Up to 2,000,000 Solution Problem #3
2,000,001 to 5,000,000 17.00%
More than 5,000,000 19.00%
Preferred Equity Up to 500,000 Solution Problem #3
More than 500,000 8.50%
Debt Up to 2,000,000 Solution Problem #3
2,000,001 to 5,000,000 7%
More than 5,000,000 9%
a) Enter the above information using custom number formats to format the “Range” column. Note that
some of the answers should be linked to your solution to the previous question.
b) Using this information, calculate each of the break-points.
c) Create a chart of the firm’s marginal WACC curve using the market value weights. Make sure that it
is a perfect step function.
Chapter 11: The Cost of Capital 67
Instructor’s Manual Problem Set

5. Readable Materials Inc., a manufacturer of coated freshet and coated ground-wood paper used
in catalogs, magazines, and commercial printing applications, has three bond issues
outstanding. The following table describes these issues:
Issue A Issue B Issue C
Price $850.00 $1,150.00 $900.00
Face Value $1,000.00 $1,000.00 $1,000.00
Coupon Rate 7.00% 11.00% 9.00%
Frequency Semiannually Annually Quarterly
Maturity (Years) 15 20 30
Number of Bonds 1,000 2,000 3,000

In addition, the firm’s 100,000 preferred shares of stock pay $0.75 per share quarterly and
currently have a market price of $30 per share and a book value of $20 per share. The flotation
costs for debt, preferred, and common equity are 3%, 5%, and 7%, respectively. The current
price per share of the firm’s 200,000 shares of common stock is $50, but they have book value of
$30 per share. The firm expects an average common dividend growth rate of 3% indefinitely
and a dividend yield of 12% for the next year. The firm’s beta coefficient is 1.5 and its marginal
tax rate is 40%. If the current risk free rate and market risk premium are 3% and 7%
respectively, answer the following:
a) What are the book and market value weights for each source of capital?
b) What are the component costs of capital (i.e., debt, preferred equity, retained earnings, and new
common equity)? Use the weighted average of the bond market values to determine the cost of debt
and the arithmetic average of the dividend discount model and CAPM model for the cost of retained
earnings.
c) What is the weighted average cost of capital using both the market and book value weights?

6. Metallic Engineering, Inc., a manufacturer of fabricated aluminum products for aerospace,


engineering, automotive, and custom industrial applications, is calculating its WACC. The
firm’s common stock just paid a dividend of $1.5 per share and now is selling for $30. The
firm’s financial staff estimates the company’s new product will generate an unusual high
dividend growth rate of 17% for four years. After this period of time, the dividend growth rate
will decline to 3% during a transition period of 3 years, rather than instantaneously. The firm’s
debt-to-equity ratio is 3/4 and the flotation costs for new equity will be 7%. Also, the firm has a
payout ratio of 60% and 20M of common shares of stock outstanding.
a) Based on the information above, determine the firm’s estimated retained earnings and the associated
break-point.
b) Calculate the firm’s cost of retained earnings and the cost of new common equity. Hint: use the
required rate of return kCS derived from the H-Model formula in Chapter 9 as follows:
𝐷0 𝑛1 + 𝑛2
𝑘𝐶𝑆 = 𝑔2 + [(1 + 𝑔2 ) + (𝑔1 − 𝑔2 )]
𝑉𝐶𝑆 2
c) If Metallic Engineering’s after-tax cost of debt is 5%, determine the WACC with retained earnings
and new common equity.
68 Chapter 11: The Cost of Capital
Instructor’s Manual Problem Set

Chapter 11: Multiple Choice Questions

1. What are the correct formulas for cells B2 and B3?


a) =B1/(1-B1) and =1/(1-B1)
b) =B1/(1+B1) and =1/(1+B1)
c) =B1/(1+B1)^2 and =1/(1+B1)^2
d) =B1/(1-B1)^2 and =1/(1-B1)^2
e) =B1/(B1-1) and =1/(B1-1)
Solution: b

2. What is the correct formula for cell B6?


a) =B1*B5*B3+B4*B2
b) =B3*B1+B4*B2*(1-B5)
c) =B3*B1+B4*B2
d) =B3*(B1*(1-B5))+B4*B2
e) =B3*(B1*(1+B5))+B4*B2
Solution: d

3. What should be the correct formula for cell B5?


a) =B2/(1-B1)+B3*B4*B1/(1-B1)
b) =B2/(1+B1)+B3*(1-B4)*B1/(1+B1)
c) =B2/(1+B1)+B3*B1/(1+B1)
d) =B2/(1-B4)+B3*B1/(1-B4)
e) =B2/(1-B1)+B3/(1-B1)
Solution: c

4. What is the value of cell B5?

a) 29
b) 32
c) 47
d) 49
e) 53
Solution: a
Chapter 11: The Cost of Capital 69
Instructor’s Manual Problem Set

5. What is the correct formula for B7 to find the cost of retained


earnings using the CAPM?
a) =B5+B4*B6
b) =B1/B3+B2
c) =B3/B1+B2
d) =B4*B6+B2
e) =B5+B4*(B6-B5)
Solution: e

6. What is the correct formula for B7 to find the cost of retained


earnings using the constant growth dividend discount model?
a) =B5+B4*B6
b) =B1/B3+B2
c) =B3/B1+B2
d) =B4*B6+B2
e) =B5+B4*(B6-B5)
Solution: b

7. What is the correct formula for cell B6?


a) =B5*(1-B3)/B4
b) =B5*(1-B4)/B3
c) =B5*B4/B3
d) =B5*B3/B4
e) =B5*(1-B3)/B2
Solution: b

8. What is the correct formula for B7 to find the cost of new


common equity using the constant growth dividend discount
model?
a) =B5+B4*B6
b) =B1/B3+B2
c) =B3/B1+B2
d) =B1/(B3*(1-B4))+B2
e) =B5+B4*(B6-B5)*(1-B4)
Solution: d
70 Chapter 11: The Cost of Capital
Instructor’s Manual Problem Set

9. What is the correct formula in B9 to calculate the after-tax cost of


debt?
a) =YIELD(B1,B2,B3,B4*(1-B8)/B5*100,B5/B5*100,B6,B7)*(1-B9)
b) =YIELD(B1,B2,B3,B4*(1-B8)/B5*100,B5/B5*100,B6,B7)
c) =YIELD(B1,B2,B3,B4*(1-B9)/B5*100,B5/B5*100,B6,B7)*(1-B8)
d) None of the above

Solution: a

10. What is the correct formula in B8 to calculate the after-tax cost


of debt?
a) =RATE(B1*B5,B2/B5*B4,-B3*(1-B6),B4)
b) =RATE(B1*B5,B2/B5*B4,-B3*(1-B6),B4)*B5*(1-B7)
c) =RATE(B1*B5,B2/B5*B4,-B3,B4)*B5*(1-B7)
d) =RATE(B1*B5,B2/B5*B4,-B3*(1-B6),B4)*(1-B7)

Solution: b

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