Cost of Capital Problems
1.
The Southwest Manufacturing Corp. (SMC) has a target capital structure of 50% debt
and 50% equity. SMC is forecasting $16.2 million in retained earnings, and its last
dividend was $1.00 The firm is expected to grow 10%annually indefinitely. The common
stock is currently selling at $28.25 per share. Flotation costs of a new issue would be
15%. The firm’s before-tax cost of debt is 12%, and its marginal tax rate is 40%. An
ambitious capital expenditure program is under consideration for this year. Total dollar
expenditures for each project and expected rates of return are given below:
Amount
Project A
Project B
Project C
Project D
IRR
$20 million
10 million
10 million
20 million
14.0%
12.0%
10.5%
9.2%
Assume retained earnings will be utilized before any new stock is issued. All projects, if
accepted, must be taken in their entirety,i.e, you cannot accept one-half of a project.
What is SMC’s present cost of debt and retained earnings? (12% pre-tax and 7.2% aftertax and 13.89% for retained earnings)
What is the firm’s initial WACC?
(WACC 10.55%)
How much new capital can SMC raise before its marginal cost of capital increases? What
isthe firm’s cost of new common equity and WACC when new stock is required?
(Break point $32.4 m; cost of common equity 14.58%; WACC 10.89%)
What is SMC’s optimal capital budget for this year? What projects should be accepted?
2.
Ross and Sons has a target capital structure that calls for 40% debt, 10% preferred and
50% equity. The firms current after-tax cost of debt is 6% and it can sell as much debt as
it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a
dividend of $10 per share; however the firm will net only $80 per share from the sale of
new preferred stock Ross expects to retain $15 million in earnings over the next year.
Ross' common stock currently sells for $40 per share, but the firm will net only $34 per
share from the sale of new common stock. The firm recently paid a dividend of $2 per
share on its common stock, and investor expect the dividend to grow indefinitely at a
constant rate of 10% per year.
Ross expects to make investments of approximately $45 million this year. What will their
WACC (external) be at this level of investment? Show your work. (Kps = 12.5%, Ke =
16.47%, WACC 11.89%)
3.
Gulf Electric Co. (GEC) uses only debt and equity in its capital structure. It can borrow
unlimited amounts at an interest rate of 10% so long as it finances at its target capital
structure of 55% debt and 45% common equity. Its last dividend was $2.20, its expected
constant growth rate is 6%, its stock sells on the NYSE at a price of $35, and new stock
would net the company $30 after flotation costs. GEC’s tax rate is 40%, and it expects to
have $100 million of retained earnings this year.
What is GEC’s cost of equity from newly issued stock? (13.77%)
What would be their cost of capital for projects of average risk if the total capital budget
were $150 million? (WACC Internal 9% ; WACC External 9.5%)
Will this cost of capital go up at any point? Why and how much? ($222,222,222.22)
Are there any potential drawbacks to using the firm’s WACC as the required rate of return
for all of the projects that the firm evaluates? Explain.
4.
AMR, parent company of American Airlines, is considering buying a fleet of new planes.
Mr. Zomboni, the CFO, wants to know what the firm's cost of capital is going to be before
the company makes a decision. AMR is currently capitalized with 40% debt, 50% equity,
and 10% preferred stock and has no plans to change these percentages. AMR bonds
($1000 maturity value) currently sell for $949, have 16 years to maturity, and have a 12%
coupon rate with interest paid semi-annually. AMR's preferred stock currently sells for
$80 and has an annual dividend of $11. AMR's common stock has a current price of $85
and next year's dividend is expected to be $7. The firm's earnings and dividends are
expected to grow at an annual rate of 6.5% indefinitely. The firm's marginal tax rate is
40%. What is the firm's marginal cost of capital (WACC) using internal equity? (WACC
Internal 11.81%)
5.
Tom Thumb Stores has 4,000,000 shares outstanding selling at $9 each. They have 20,000
bonds outstanding, each with a par value of $1000 and selling at 85% of par. The firm also
has preferred stock outstanding with a market value of $4,000,000. What is the Tom
Thumb's capital structure?
6.
AMR has been told that if they borrow from a bank instead of issuing bonds that they can
borrow up to $50 million at 9%, another $40 million at 9.5% and another $10 million at
10%. At what levels of investment will they have a break points in their cost of capital
based on the cost of debt increasing? ($125,000,000; $225,000,000; $250,000,000)
7.
Heavy Metal Corp. is a steel manufacturer that finances its operations with 50 percent
debt, 10 percent preferred stock and 40 percent equity. Its net income is $100 million and
its dividend payout ratio is 35 percent. The company’s bonds currently sell for $1,025 and
their coupon rate is 11 percent with 14 years remaining to maturity. The preferred stock
pays an annual dividend of $2 and sells for $20 per share. The company’s common stock
trades at $30 a share and its current dividend (already paid this year) of $2 a share is
expected to grow at a constant rate of 8 percent per year. The flotation cost of external
equity is 15 percent and the flotation cost on preferred stock is 10 percent. The bonds
have minimal flotation costs of $15 each because the bonds are primarily privately placed.
The company estimates that its capital budget will be in the neighborhood of $200 million.
The firm’s marginal tax rate is 34 percent. What is the firm’s WACC at this level of
investment? (WACC external 11.28%)
What is the maximum amount that the firm could invest and still be at the firm’s minimum
cost of capital? (BP $162,500,00)
How would it affect the situation if your cost of debt were going to increase after the firm
had issued $50 million in bonds?
8.
If a moderately stable firm was using no debt at all in their capital structure and made the
decision to borrow money for worthy projects so that their new capital structure was
10% debt and 90% equity, would you expect this to positively or negatively affect their
stock price? Why?
9.
Currently, your firm is at its target debt ratio. You need to raise money for a very exciting
new project that has massive profit potential. Why might it be in the best interest of your
current stockholders to temporarily go above your target debt ratio and raise the capital
with debt as opposed to selling new stock?
10. Explain what you think would happen to a company’s stock price when it is able to find
projects returning more than the firm’s WACC? Explain in precise terms why this
happens.
11. Would it be naïve for a firm to use its WACC to evaluate all capital budgeting proposals?
What would be the disadvantages of that approach? How do most large corporations do
this in practice?
12. Johnson Industries finances its projects with 40% debt, 10% preferred stock and 50%
common stock.
The company can issue bonds at a YTM of 8.4%
The cost of preferred stock is 9%.
The company's common stock currently sells for $30 per share.
Next years dividend is expected to be $2.12 and is expected to grow at 6%per year
indefinitely.
If the company issues new common stock it must pay flotation cost of $1.00 per share.
Assume that the flotation cost on debt and preferred stock is zero.
The company's capital budget is $600,000.
The company has $200,000 in retained earnings.
The company's tax rate is 30%.
What is the company's WACC using internal equity (retained earnings)?
9.79%)
(WACC
Can the firm complete its entire capital budgeting program at this WACC? Explain. Show
your calculation?
13. The capital structure of Victorian Industries, Inc.is provided below. Flotation costs would
be (a) 13% of market value for a new bond issue, (b) $1.10 per share for common stock,
and (c) $1.80 per share for preferred stock. The dividends for common stock were $3.30
last year and are projected to have an annual growth rate of 5%. The firm is in a 34% tax
bracket. What is the weighted cost of capital if the firm finances in the proportions shown
below? Market prices are $1020 for bonds, $17 for preferred stock and $40 for common
stock. There will be $325,000 of retained earnings available.
Security
Percent of Capital
Bonds (7% coupon, 15 year maturity)
30%
Preferred stock (6000 shares outstanding, $50 par, $1.45 dividend)
20%
Common stock
50%
Total
100%
(WACC Internal 10.13%, WACC External 10.25%)
Under what situations would it be appropriate to use the cost of capital determined as
your required rate of return for new projects?
Does a firm’s WACC remain constant? Why or why not?
14. Murphy Industries (a producer of hot air balloons) is considering some new projects and
wants to know what a proper required rate of return should be. You are the CFO (chief
financial officer) for Murphy and the task has landed on your desk. You know that the
firm recently paid a dividend on its common stock of $1.50 and that the stock is selling for
$15. The earnings and dividends of the firm have been growing at approximately 7% of
the selling price. The firm has bonds (semi-annual interest payments) outstanding with a
coupon rate of 12%, which are currently selling for $980 and have 10 years left until
maturity. Flotation costs on bonds usually run about 5% of the selling price of the bonds.
The firm has preferred stock outstanding with a dividend of $14 per year, a market price
of $100, with expected flotation costs on a new issue running about $8 per share. The firm
is in a marginal tax bracket of 34%, has $1,500,000 in retained earnings and has the
following target capital structure:
Debt
Preferred Stock
Common Stock
50%
10%
40%
Calculate the firm's cost of debt
Calculate the firm's cost of preferred
Calculate the firms internal and external cost of equity
Calculate the firm's WACC using internal, then external equity
At what level of investment will the firm's WACC increase?
Murphy is considering a wide range of investment including everything from replacement
of some copiers to an investment in natural gas wells, which is an entirely new area of
investment for the firm.
Is this WACC appropriate for all these?
What projects can we use this WACC for?
Are there any other requirements for using this WACC as our required rate of return?
What are the drawbacks of using WACC for projects it is not suited for. Give specific
examples.