CHAPTER 10
The Cost of Capital
Problem solving
Lidija Dedi
9-1
Problem 1:
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Your company’ stock sells for $50 per
share,
its last dividend was $2, its growth rate
is a constant 5%, and the company will
incur a flotation cost of 15% if it sells
new common stock.
What is the firm’s cost of new equity?
9-2
Problem 2:
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Alpha’s stock currently has a price of $50 per
share and is expected to pay a year-end
dividend of 2,50 per share.
The dividend is expected to grow at a constant
rate of 4% per year
The company has insufficient retained earnings
to fund capital projects and must therefore,
issue new common stock.
The new stock has an estimated flotation cost of
$3 per share
What is the company’s cost of equity capital?9-3
Problem 3:
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Current market price of the firm’s stock
is $28
Its last dividend was $2,20
Its expected dividend growth rate is 6%
Calculate cost of retained
earnings?
9-4
Problem 4:
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The company capital structure is 70% equity
and 30% debt
The yield to maturity on the company’s bonds
is 9%
The company’s year-end dividend is
forecasted to be $0,80 a share
The company expects that its dividend will
grow at a constant rate of 9% a year
The company’s stock price is $25
The company’s tax rate is 40%
9-5
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The company anticipates that it will
need to raise new common stock this
year
Its investment bankers anticipate that
the total flotation cost will equal 10% of
the amount issued
Assume the company accounts for
flotation costs by adjusting the cost of
capital
Calculate the company’s WACC
9-6
Problem 5:
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Company’s capital structure
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40% debt
60% common equity
The company has 20-year bonds
outstanding with a 9% annual coupon
that are trading at par
Tax rate is 40%
9-7
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The risk-free rate is 5,5%
The market risk premium is 5%
The stock beta is 1,4
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Calculate the company’s WACC
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9-8
For the same company
calculate WACC if
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Market value of the company’s bonds is
$80 and
Nominal value of the bonds is 100
9-9
Problem 6:
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A company has determined that its optimal
capital structure consists of 40 percent debt
and 60 percent equity.
Assume the firm will not have enough
retained earnings to fund the equity portion
of its capital budget.
Also, assume the firm accounts for flotation
costs by adjusting the cost of capital.
Given the following information,
calculate the firm’s weighted average
cost of capital
9-10
Problem 7:
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Alfa Corp. Wants to calculate its weighted
average cost of capital (WACC)
CFO has the following information:
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The company’s long-term bonds currently offer a
yield to maturity of 8%
The company’s stock price is $32 a share
The company recently paid a dividend of $2 a
share
The dividend is expected to grow at a constant
rate of 6% a year
9-11
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The company pays a 10% flotation cost
whenever it issues new common stock
The company’s target capital structure is
75% equity and 25% debt
The company’s tax rate is 40%
The firm will be able to use retained
earnings to fund the equity portion of its
capital budget
What is the company’s WACC?
9-12
Problem 8:
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Johnson Industries finances its projects with
40% debt, 10% preferred stock, and 50%
common stock.
The company can issue bonds at a yield to
maturity of 8,4%
The cost of preferred stock is 9%
The risk-free rate is 6,57%
The market risk premium is 5%
Johnson Industrie’s beta is equal to 1,3
9-13
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Assume that the firm will be able to use
retained earnings to fund the equity
portion of its capital budget
The company tax rate is 30%
What is the company’s weighted
average cost of capital (WACC)?
9-14
Problem 9:
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Company has a weighted average cost
of capital of 11,5%
Its target capital structure is 55 percent
equity and 45 percent debt
The company has sufficient retained
earnings to fund the equity portion of
its capital budget
The before-tax cost of debt is 9%
9-15
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The company’s tax rate is 30%
If the expected dividend next period is
$5 and the current stock price is $45,
what is the company’s growth rate?
9-16
Problem 10:
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ABC Steel has a capital structure with
30 percent debt (all long-term bonds)
and 70 percent common equity
The yield to maturity on the company’s
long-term bonds is 8%
The firm estimates that its overall
composite WACC is 10%
9-17
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The risk-free rate of interest is 5,5%
The market risk premium is 5%
The company’s tax rate is 40%
ABC uses CAPM to determine its cost of
equity
What is the beta on ABC’s stock?
9-18
Problem 11:
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Arizona Inc., an all-equity firm, currently has a
beta of 1,25
Risk-free rate 7%
Return for the “market” (KM) 14%
Suppose the firm sells 10% of its assets with
beta = 1,25 and purchase the same proportion of
new assets with a beta of 1,1
What will be the firm’s new overall
required rate of return, and what rate of
return must the new assets produce in
order to leave the stock price unchanged?
9-19
Problem 12:
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ABC Motors just reported earnings per share of
$2,00
The stock has a price earnings ratio of 40, so
the stock’s current price is $80 per share
Analysts expect that one year from now the
company will have an EPS of $2,40 and it will
pay its first dividend of $1,00 per share
The stock has a required return of 10%
What price earnings ratio must the stock
have one year from now so that investors
realize their expected return?
9-20