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# Chapter 15

Cost of Capital

McGraw-Hill/Irwin

## Questions and Problems

1. With the information given, we can find
the cost of equity using the dividend
growth model. Using this model, the cost
of equity is:

## RE = [420(1.06)/ 6500] + .06 = .1285 or

12.85% (See Eq. 15.1)

## 2. Calculating Cost of Equity

The Tubby Ball Corporation's common
stock has a beta of 1.2. If the risk-free rate
is 4.5 percent and the expected return on
the market is 13 percent, what is Tubby
Ball's cost of equity capital?

## 2. Here we have information to

calculate the cost of equity using the
CAPM. The cost of equity is:

or 14.70%

## 3. Calculating Cost of Equity

Stock in Parrothead Industries has a beta
of 1.15. The market risk premium is 8
percent, and T-bills are currently yielding 4
was \$1.80 per share, and dividends are
expected to grow at a 5 percent annual
rate indefinitely. If the stock sells for \$34
per share, what is your best estimate of

## 3. We have the information available to

calculate the cost of equity using the
CAPM and the dividend growth model.
Using the CAPM, we find:

## RE = .04 + 1.15(.08) = .1320 or 13.20%

And using the dividend growth model, the
cost of equity is

10.56%

## Both estimates of the cost of equity seem

reasonable. If we remember the historical return
on large capitalization stocks, the estimate from
the CAPM model is about one percent higher
than average, and the estimate from the dividend
growth model is about one percent lower than
the historical average, so we cannot definitively
say one of the estimates is incorrect. Given this,
we will use the average of the two, so:

## 4. Estimating the DCF Growth Rate

Suppose Massey Ltd., a company based in New
Zealand, just issued a dividend of \$1.22 per
share on its common stock. The company paid
dividends of \$.78, \$.91, \$.93, and \$1.00 per
share in the last four years. If the stock currently
sells for \$52, what is your best estimate of the
company's cost of equity capital using the
arithmetic average growth rate in dividends?
What if you use the geometric average growth
rate?

## 4. To use the dividend growth model, we first need to

find the growth rate in dividends. So, the increase in
dividends each year was:

was:

12.10%

## Using this growth rate in the dividend growth model,

we find the cost of equity is:

14.73%

## Calculating the geometric growth rate in

dividends, we find:
\$1.22 = \$0.78(1 + g)4
g = .1183 or 11.83%
The cost of equity using the geometric
dividend growth rate is:
RE = [\$1.22(1.1183)/\$52.00] + .1183 =
14.46%

## 5. Calculating Cost of Preferred Stock

Nanning Bank has an issue of preferred
stock with a 48 yuan stated dividend that
just sold for 725 yuan per share. What is
the bank's cost of preferred stock?

## 5. The cost of preferred stock is the

dividend payment divided by the price, so:

6.62%

## 6. Calculating Cost of Debt

Minsk Diamonds is trying to determine its
cost of debt. The firm has a debt issue
outstanding with 12 years to maturity that
is quoted at 104 percent of face value. The
issue makes semiannual payments and
has an embedded cost of 8 percent
annually. What is Minsk's pretax cost of
debt? If the tax rate is 35 percent, what is
the after tax cost of debt?

## 6. The pretax cost of debt is the YTM of the

companys bonds, so:

## P0 = RUR 1,040 (1,000*(1+0.04))

Coupon = 40 (1,000*8%*0.5)

T=24

R = 3.745%

## 7. Calculating Cost of Debt

Moldova Beef Farm issued a 25-year, 9
percent semiannual bond 7 years ago. The
bond currently sells for 108 percent of its
face value. The company's tax rate is 35
percent.
a. What is the pretax cost of debt?
b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the
after tax cost of debt? Why?

## 7. a.The pretax cost of debt is the YTM of the

companys bonds, so:

P0 = \$1,080

Coupon = 45 (1,000*9%*0.5)

T=(25-7)*2

R = 4.075%

## YTM = 2 4.075% = 8.15%

b.
The aftertax cost of debt is:

## RD = .0815(1 .35) = .0529 or 5.29%

c.
The after-tax rate is more relevant
because that is the actual cost to the company.

## 8. Calculating Cost of Debt

For the firm in Problem 7, suppose the book
value of the debt issue is 50 million lei. In
addition, the company has a second debt issue
on the market, a zero coupon bond with seven
years left to maturity; the book value of this issue
is 170 million lei and the bonds sell for 58
percent of par. What is the company's total book
value of debt? The total market value? What is
your best estimate of the after tax cost of debt
now?

## 8. The book value of debt is the total par value

of all outstanding debt, so:

## To find the market value of debt, we find the

price of the bonds and multiply by the number of
bonds. Alternatively, we can multiply the price
quote of the bond times the par value of the
bonds. Doing so, we find:

## The YTM of the zero coupon bonds is:

PZ = 580 = 1,000
T=7
R = 8.09%
So, the after tax cost of the zero
coupon bonds is:

## The after tax cost of debt for the

company is the weighted average of the
after tax cost of debt for all outstanding
bond issues. We need to use the market
value weights of the bonds. The total after
tax cost of debt for the company is:

RD = .0529*(54/152.6) + .0526*(98.6/
152.6) = .0527 or 5.27%

9. Calculating WACC
Mullineaux Corporation has a target capital
structure of 50 percent common stock, 10
percent preferred stock, and 40 percent debt. Its
cost of equity is 16 percent, the cost of preferred
stock is 7.5 percent, and the cost of debt is 9
percent. The relevant tax rate is 35 percent.
a. What is Mullineaux's WACC?
b. The company president has approached you
about Mullineaux's capital structure. He wants to
know why the company doesn't use more
preferred stock financing, since it costs less than
debt. What would you tell the president?

9. a.
Using the equation to calculate the
WACC, we find:

## WACC = .50(.16) + .10(.075) + .40(.09)

(1 .35) = .1109 or 11.09%

b.
Since interest is tax deductible and
dividends are not, we must look at the after-tax
cost of debt, which is:

## Hence, on an after-tax basis, debt is

cheaper than the preferred stock.

## 10. Taxes and WACC

Oman Manufacturing has a target debtequity ratio of .70. Its cost of equity is 18
percent and its cost of debt is 10 percent.
If the tax rate is 35 percent, what is
Oman's WACC?

## 10.Here we need to use the debt-equity

ratio to calculate the WACC. Doing so, we
find:

## WACC = .18(1/1.70) + .10(.70/1.70)(1

.35) = .1326 or 13.26%

## 11. Finding the Target Capital Structure

Sao Paulo Llamas has a weighted average
cost of capital of 11.5 percent. The
company's cost of equity is 15 percent and
its cost of debt is 9 percent. The tax rate is
35 percent. What is Captain's target debtequity ratio?

11. Here we have the WACC and need to find the debtequity ratio of the company. Setting up the WACC
equation, we find:

## Now we must realize that the V/E is just the equity

multiplier, which is equal to:

V/E = 1 + D/E

## Now we can solve for D/E as:

.0565(D/E) = .0350

D/E = .6195

## 15. Finding the WACC

Given the following information for Alexandria Power
Company find the WACC. Assume the company's tax
rate is 35 percent.
Debt: 4,000 7 percent coupon bonds outstanding, EGP
1,000 par value, 20 years to maturity, selling for 105
percent of par; the bonds make semiannual payments.
Common stock: 90,000 shares outstanding, selling for
EGP 60 per share; the beta is 1.10.
Preferred stock: 13,000 shares of 6 percent preferred
stock outstanding, currently selling for EGP 110 per
share.
Market: 8 percent market risk premium and 6 percent
risk-free rate.

## 15. We will begin by finding the market value of

each type of financing. We find:

4.12M

## MVE = 90,000(EGP 60) = EGP 5.40M

MVP = 13,000(EGP 110) = EGP 1.430M
And the total market value of the firm is:
V = EGP 4.12M + 5.40M + 1.430M = EGP
10.95M

## Now, we can find the cost of equity

using the CAPM. The cost of equity is:

## The cost of debt is the YTM of the

bonds, so:
P0 = EGP 1,030 =
Coupon= 1,000*7%*0.5
T=40
R = 3.36%
YTM = 3.36% 2 = 6.72%
And the aftertax cost of debt is:
RD = (1 .35)(.0672) = .0437 or 4.37%

## The cost of preferred stock is:

RP = EGP 6/EGP 110 = .0546 or 5.46%

## Now we have all of the components to

calculate the WACC. The WACC is:

WACC = .0437(4.12/10.95) + .
1480(5.40/10.95) + .0546(1.43/10.95) =
9.57%

## Notice that we didnt include the (1

tC) term in the WACC equation. We simply
used the aftertax cost of debt in the
equation, so the term is not needed here.

## 17. SML and WACC

An all-equity firm is considering the following
projects: The T-bill rate is 5 percent, and the
expected return on the market is 13 percent.
a. Which projects have a higher expected return
than the firm's 12 percent cost of capital?
b. Which projects should be accepted?
c. Which projects would be incorrectly accepted
or rejected if the firm's overall cost of capital
were used as a hurdle rate?

17. a.
Projects X, Y and Z.
b.
Using the CAPM to consider the projects, we need to
calculate the expected return of the project given its level of risk. This
expected return should then be compared to the expected return of
the project. If the return calculated using the CAPM is higher than the
project expected return, we should accept the project, if not, we
reject the project. After considering risk via the CAPM:
E[W] = .05 + .60(.13 .05) = .0980 < .11, so
accept W
E[X]
= .05 + .90(.13 .05) = .1220 < .13, so
accept X
E[Y]
= .05 + 1.20(.13 .05) = .1460 > .14, so reject
Y
E[Z]
= .05 + 1.70(.13 .05) = .1860 > .16, so reject
Z
Project W would be incorrectly rejected; Projects Y and Z would be
incorrectly accepted.

## 18. Calculating Flotation Costs

Suppose your company needs 15 million Czech koruny to
build a new assembly line. Your target debt-equity ratio is .
90. The notation cost for new equity is 10 percent, but the
flotation cost for debt is only 4 percent. Your boss has
decided to fund the project by borrowing money, because
the flotation costs are lower and the needed funds are
relatively small.
a. What do you think about the rationale behind borrowing
the entire amount?
b. What is your company's weighted average flotation
cost?
c. What is the true cost of building the new assembly line
after taking flotation costs into account? Does it matter in
this case that the entire amount is being raised from debt?

## 18.a. He should look at the weighted

average flotation cost, not just the debt
cost.

## b. The weighted average floatation

cost is the weighted average of the
floatation costs for debt and equity, so:

or 7.20%

## c. The total cost of the equipment

including floatation costs is:

16,156,463

## Even if the specific funds are

actually being raised completely from debt,
the flotation costs, and hence true
investment cost, should be valued as if the
firms target capital structure is used.

## 19. Calculating Flotation Costs

Romania Alliance Company needs to raise 25
million lei to start a new project and will raise the
money by selling new bonds. The company has
a target capital structure of 60 percent common
stock, 20 percent preferred stock, and 20 percent
debt. Flotation costs for issuing new common
stock are 11 percent, for new preferred stock, 7
percent, and for new debt, 4 percent. What is the
true initial cost figure Southern should use when
evaluating its project?

## 19.We first need to find the weighted

average floatation cost. Doing so, we find:

or 8.8%

## And the total cost of the equipment

including floatation costs is:

27,412,281

## WACC and NPV

Davao Timber, is considering a project that will result in
initial aftertax cash savings of 4.0 million Philippine pesos
at the end of the first year, and these savings will grow at
a rate of 5 percent per year indefinitely. The firm has a
target debt-equity ratio of .65, a cost of equity of 15
percent, and an after tax cost of debt of 5.5 percent. The
cost-saving proposal is somewhat riskier than the usual
project the firm undertakes; management uses the
subjective approach and applies an adjustment factor of
+2 percent to the cost of capital for such risky projects.
Under what circumstances should Davao take on the
project?

## 20.Using the debt-equity ratio to calculate

the WACC, we find:
WACC = (.65/1.65)(.055) + (1/1.65)(.15) = .
1126 or 11.26%
Since the project is riskier than the
company, we need to adjust the project
discount rate for the additional risk. Using
the subjective risk factor given, we find:
Project discount rate = 11.26% + 2.00% =
13.26%

## We would accept the project if the NPV is

positive. The NPV is the PV of the cash outflows
plus the PV of the cash inflows. Since we have
the costs, we just need to find the PV of inflows.
The cash inflows are a growing perpetuity. If you
remember, the equation for the PV of a growing
perpetuity is the same as the dividend growth
equation, so:
PV of future CF = PHP 4,000,000/(.1326 .05) =
PHP 48,440,367

## The project should only be undertaken

if its cost is less than PHP 48,440,367
since costs less than this amount will result
in a positive NPV.

## 21. Flotation Costs Knight, Inc., recently issued

new securities to finance a new TV show. The
project cost \$2.1 million and the company paid
\$128,000 in flotation costs. In addition, the equity
issued had a flotation cost of 7 percent of the
amount raised, whereas the debt issued had a
flotation cost of 2.5 percent of the amount raised.
If Knight issued new securities in the same
proportion as its target capital structure, what is
the company's target debt-equity ratio?

## 21.The total cost of the equipment including

floatation costs was:
Total costs = \$2.1M + 128,000 = \$2.228M
Using the equation to calculate the total cost
including floatation costs, we get:
Amount raised(1 fT) = Amount needed
after floatation costs

## \$2.228M(1 fT) = \$2.1M

fT = .0575 or 5.75%

## Now, we know the weighted average

floatation cost. The equation to calculate
the percentage floatation costs is:
fT = .0575 = .07(E/V) + .025(D/V)
We can solve this equation to find the
debt-equity ratio as follows:

## We must recognize that the V/E term is the

equity multiplier, which is (1 + D/E), so:
.0575(D/E + 1) = .07 + .025(D/E)
D/E = .3867

Chapter 15
End of Chapter

McGraw-Hill/Irwin