MM5007 FINANCIAL MANAGEMENT

RISK & RETURN AND THE COST OF CAPITAL

1. You have been given the expected return data shown in the first table on three assets—F, G, and H—
over the period 2013–2016.

Expected Return
Year
Asset F Asset G Asset H
2013 16% 17% 14%
2014 17 16 15
2015 18 15 16
2016 19 14 17

Using these assets, you have isolated the three investment alternatives shown in the following
table.

Alternative Investment Coefficient of correlation

1 100% of asset F
2 50% of asset F and 50% of asset G -0.75
3 50% of asset F and 50% of asset H 0.75

a. Calculate the expected return over the 4-year period for each of the three alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three
alternatives.
d. On the basis of your findings, which of the three investment alternatives do you recommend? Why?

2. Lang Enterprises is interested in measuring its firm cost of capital. Current investigation has gathered the
following data. The borrowing firm’s tax corporate rate is 34%.

Debt The firm has recorded short term debt in the amount of $1,000,000 on their balance sheet. Also,
the firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year bonds on which
annual interest payments will be made priced at $1,150. The firm has 1,500 bonds outstanding.

Preferred stock The firm issue 7% preferred stock on $100 par value. If a new issue is offered, the new
shares would sell for $85 per share. Currently the firm’s outstanding preferred stock is 2,000 shares.

Common stock The firm’s common stock is currently selling for $25 per share. The firm paid cash
dividends of $1 per share last year. The firm’s dividends have been growing at an annual rate of 5%, and
this growth is expected to continue into the future. The firm has 100,000 shares of common stock
outstanding.

The firm also contemplating upon changing their capital structure to the following structure below in
several years ahead:
 Source of Financing Target Market Value
Debt 3,500,000.00
Preferred Stock 300,000.00
Common Stock 2,500,000.00
Total 6,300,000.00

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.
c. Calculate the cost of common stock.
d. Calculate the firm’s weighted average cost of capital based on its current market value (historical
data) and target market. What could you infer from the result?