FN1 Module 7 Handout #2
Past Exam Questions
Question 1:
Silly Wicket’s outstanding preferred shares have a current market price of $11 per share,
a par value of $10, and a stated dividend rate of 7%. Silly Wicket’s underwriters have
advised management that if it wishes to issue new preferred shares, it will attach flotation
costs of 6% before tax. What is the component cost of Silly Wicket’s preferred shares if
its tax rate is 38%?
1) 4.10%
2) 6.61%
3) 6.77%
4) 7.27%
Method 1:
Kp = __D___
(P – Fat)
Given:
Dividend = 7%*10 = 0.70
Price = 11
Fat = 0.06*(1-.38)*11 = 0.0372*11 = 0.4092
Kp = ___ 0.70___ = 6.61%
(11 – 0.4092)
Method 2: Use equation
Kp = Rp * ___P__
NP
Rp = D/P = 0.70/11= 6.36%
NP = 11 – (1-0.38)*0.06*11 = 10.5908
Kp = 0.0636 * 11/10.5908 = 6.61%
1
FN1 Module 7 Handout #2
Past Exam Questions
Question 2:
BBB Ltd. has been advised that it can issue new debt at par if it offers a
coupon rate of 11.5% paid semi-annually. If flotation costs on new debt are
4% after tax and BBB ’s tax rate is 38%, what is BBB ’s component cost of
debt?
1)
2)
3)
4)
7.34%
7.43%
7.64%
12.32%
Solution:
As we are not given the term of the new debt, we cannot use the exact formula. In
this case, we must use the approximation formula:
First – determine the Effective annual rate that is equivalent to 11.5% compounded
semi-annually.
(1 + 0.115)2 – 1 = 11.83%
This is the investors’ required return.
Next – use the approximation formula:
Kb = Required Return*(1-T)
1 - Fat
Kb = 0.1183* (1-0.38)
0.96
=
7.64%
2
FN1 Module 7 Handout #2
Past Exam Questions
Question 3:
The beta on CCC Inc.’s common shares is 1.35, the risk-free rate of
interest is 3%, and the market price of risk is 61 /2%. What is CCC’s component
cost of equity, assuming that flotation costs on new equity are 5% after tax, its
tax rate is 37%, and it will finance new projects using retained earnings?
1)
2)
3)
4)
7.42%
11.78%
12.16%
12.39%
Solution:
As the firm will finance new projects using retained earnings, floatation costs are not
relevant. The component cost of equity is the required return for equity providers
today.
Using the CAPM:
Ke = Re = RF + beta * (RM – RF)
= 0.03 + 1.35 * (0.065) = 11.78%
3
FN1 Module 7 Handout #2
Past Exam Questions
Question 4:
DDD Ltd. currently has 75 million common shares outstanding, which
have a current market price of $3 per share. The shares paid a dividend of $0.25
per share last year, and investment analysts expect the dividends to grow at an
average annual rate of 4% for the foreseeable future. What is the component cost
of DDD’s common shares if flotation costs on new common shares are expected
to be 6% before tax, DDD’s tax rate is 35%, and DDD intends to issue new
common shares?
1)
2)
3)
4)
9.18%
12.67%
13.02%
13. 18%
Solution: For this question after tax floatation costs ARE relevant, as the firm intends
to issue new common shares.
Using the DDM:
Ke = D1 + g
NP
D1 = D0 * (1+g)
0.25 * 1.04 = 0.26
NP = P – Fat
= 3 – 3*0.06*(1-0.35) = 2.883
Ke = 0.26 + 0.04 = 13.02%
2.883
Question 5: 3 marks
When is it appropriate to use a firm’s weighted-average cost of capital to
evaluate investment projects? Explain why.
Answer:
A firm’s weighted-average cost of capital (WACC) should only be used to evaluate
projects within the firm’s risk class because it is based on investors’ perceptions of
the risk of the entire firm.
4
FN1 Module 7 Handout #2
Past Exam Questions
Question 6:
Identify two factors that might cause a company’s cost of debt to differ from its yield in
capital markets, and explain the effect of each factor.
Answer:
The cost of debt to the firm may be different than the required yield for investors due to
taxation effects, and flotation costs.
Taxation results in a reduction in cost
Flotation costs results in an increase in cost, due to the reduction in net proceeds
5