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Cost of Capital

McGraw-Hill/Irwin

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:

12.85% (See Eq. 15.1)

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?

calculate the cost of equity using the

CAPM. The cost of equity is:

or 14.70%

Stock in Parrothead Industries has a beta

of 1.15. The market risk premium is 8

percent, and T-bills are currently yielding 4

percent. Parrothead's most recent dividend

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

Parrothead's cost of equity?

calculate the cost of equity using the

CAPM and the dividend growth model.

Using the CAPM, we find:

And using the dividend growth model, the

cost of equity is

10.56%

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:

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?

find the growth rate in dividends. So, the increase in

dividends each year was:

was:

12.10%

we find the cost of equity is:

14.73%

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%

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?

dividend payment divided by the price, so:

6.62%

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?

companys bonds, so:

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

T=24

R = 3.745%

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?

companys bonds, so:

P0 = $1,080

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

T=(25-7)*2

R = 4.075%

b.

The aftertax cost of debt is:

c.

The after-tax rate is more relevant

because that is the actual cost to the company.

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?

of all outstanding debt, so:

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:

PZ = 580 = 1,000

T=7

R = 8.09%

So, the after tax cost of the zero

coupon bonds is:

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:

(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:

cheaper than the preferred stock.

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?

ratio to calculate the WACC. Doing so, we

find:

.35) = .1326 or 13.26%

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:

multiplier, which is equal to:

V/E = 1 + D/E

.0565(D/E) = .0350

D/E = .6195

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.

each type of financing. We find:

4.12M

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

using the CAPM. The cost of equity is:

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%

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

calculate the WACC. The WACC is:

WACC = .0437(4.12/10.95) + .

1480(5.40/10.95) + .0546(1.43/10.95) =

9.57%

tC) term in the WACC equation. We simply

used the aftertax cost of debt in the

equation, so the term is not needed here.

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.

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?

average flotation cost, not just the debt

cost.

cost is the weighted average of the

floatation costs for debt and equity, so:

or 7.20%

including floatation costs is:

16,156,463

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.

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?

average floatation cost. Doing so, we find:

or 8.8%

including floatation costs is:

27,412,281

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?

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%

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

if its cost is less than PHP 48,440,367

since costs less than this amount will result

in a positive NPV.

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?

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

fT = .0575 or 5.75%

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:

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

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