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Chapter: Cost of Capital
Course: Corporate Finance
Class Test
Question-1:
Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers
to be optimal:
Debt
25%
Preferred stock
15%
Common equity
60%
Total
100%
LEI’s expected net income this year is $34,285.72; its established dividend payout ratio
is 30%; its federal-plus-state tax rate is 40%; and investors expect future earnings and
dividends to grow at a constant rate of 9%. LEI paid a dividend of $3.60 per share last
year, and its stock currently sells for $54.00 per share.
LEI can obtain new capital in the following ways:
• Preferred: New preferred stock with a dividend of $11.00 can be sold to the public at
a price of $95.00 per share.
• Debt: Debt can be sold at an interest rate of 12%.
a. Determine the cost of each capital component.
b. Calculate the WACC.
c. LEI has the following investment opportunities that are average-risk projects:
Project
Cost at t = 0
Rate of Return
A
10,000
17.4%
B
20,000
16.0%
C
10,000
14.2%
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D
20,000
13.2%
E
10,000
12.0%
Which projects should LEI accept? Why?
Solution-1:
a)
Cost of Debt:
rd= rd(1-T)
= 12( 1- 0.4)
= 7.2%
Cost of Preferred Stock:
rp= D1/ P0 * 100
= 11.00/ 95.00
= 11.58%
Cost of Common Equity:
re= D1/P0 +g
= D0(1+g)/ P0 + g
= 3.6(1+0.09)/54 + 0.09
= 16.27%
b) Weight Average Cost of Capital :
WACC= wd*rd+ wp*rp+ we*re
= (.25*0.072) + (0.15*0.1158) + (0.6* 0.1627)
= 13.30%
c)
Project
Cost at t = 0
Rate of Return
Decisions
A
10,000
17.4%
Accepted
B
20,000
16.0%
Accepted
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C
10,000
14.2%
Accepted
D
20,000
13.7%
Accepted
E
10,000
12.0%
Rejected
Question-2 :
Tunney Industries can issue perpetual preferred stock at a price of $47.50 a share.
The stock would pay a constant annual dividend of $3.80 a share. What is the
company’s cost of preferred stock, rp ?
Solution-2:
Given that,
Pp= 47.50
Dp= 3.80
We know,
rp = (Dp/Pp) * 100
= (3.80/ 47.50)*100
= 8%
Question-3:
Percy Motors has a target capital structure of 40% debt and 60% common equity, with
no preferred stock. The yield to maturity on the company’s outstanding bonds is 9%,
and its tax rate is 40%. Percy’s CFO estimates that the company’s WACC is 9.96%.
What is Percy’s cost of common equity?
Solution-3:
Given that,
WACC = 9.96%
rd = 9%
T = 40%
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We know,
WACC = wd*rd + we*re
= 9.96 = [9*(1-0.4) *0.4] + (0.6*re)
= 9.96 = 2.16 + 0.6re
= 9.96 - 2.16 = 0.6re
= 7.8 = 0.6re
= re = 7.8/0.6
re = 13%
Question-4:
Javits & Sons’ common stock currently trades at $30.00 a share. It is expected to pay
an annual dividend of $3.00 a share at the end of the year (D1= $3.00), and the
constant growth rate is 5% a year.
a. What is the company’s cost of common equity if all of its equity comes from
retained earnings?
b. If the company issued new stock, it would incur a 10% flotation cost. What would be
the cost of equity from new stock?
Solution-4:
Given that,
D1= 3.00
P0= 30
g = 5%
a) We know,
Cost of Preferred Stock:
rs = Dp/Pp + g
= 3/30 + 0.05
= 15%
b) We know,
Cost of Common Equity:
re = D1/P0(1-T) + g
= 3/30(1-.10) + 0.05
= 16.11%
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Question-5:
The Patrick Company’s cost of common equity is 16%, its before-tax cost of debt is
13%, and its marginal tax rate is 40%. The stock sells at book value. Using the
following balance sheet, calculate Patrick’s WACC.
Assets
Liabilities and Equity
Cash
$120
Accounts Receivable
240
Inventories
360
Long-term debt
$1152
Plant, and equipment, net
2160
Common equity
1728
Total
$2880
Total liabilities and equity
$2880
Solution-5:
Given that,
re = 16%
rd = 13%
wd =( 1152/2880)= 0.4
we = (1728/ 2880)= 0.6
We know,
WACC = wd*rd + we*re
=(0.4*7.8) + (0.6*16)
= 12.72%
Question-6:
Hook Industries’ capital structure consists solely of debt and common equity. It can
issue debt at rd =11%, and its common stock currently pays a $2.00 dividend per share
(Do= $2.00). The stock’s price is currently $24.75, its dividend is expected to grow at a
constant rate of 7% per year, its tax rate is 35%, and its WACC is 13.95%. What
percentage of the company’s capital structure consists of debt?
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Solution-6:
Given that,
rd = 11%
Dp=2
Pp= 24.75
g=7%
T=35%
WACC=13.95%
We know,
WACC = wd*rd(1-T) + (1-wd)*rs
wd= rs- WACC/rs-rd(1-T)
= (15.64-13.95)/(15.64-7.15)
= 1.69/8.49
=20%
Question-7:
Midwest Electric Company (MEC) uses only debt and common equity. It can borrow
unlimited amounts at an interest rate of rd = 10% as long as it finances at its target
capital structure, which calls for 45% debt and 55% common equity. Its last dividend
was $2, its expected constant growth rate is 4%, and its common stock sells for $20.
MEC’s tax rate is 40%. Two projects are available: Project A has a rate of return of 13%,
while Project B’s return is 10%. These two projects are equally risky and about as risky
as the firm’s existing assets.
a. What is the cost of common equity?
b. What is the WACC?
c. Which projects should Midwest accept?
Solution-7:
a) Given that,
rd=10%
wd=45%
ws=55%
D0= 2
g = 4%
T=40%
P0=20
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We know,
Cost of Common Equity:
rs= D0(1+g)/P0 + g
= 2*(1+0.04)/20 + 0.04
= 14.4%
b)
WACC = wd*rd(1-T) + wsrs
= 0.45*[10*(1-0.4)] + (0.55*14.4)
= 10.62%
c) Midwest accept project A because it has a higher return than the WACC.
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