Problem Set: Cost of Capital and Decision

Criteria
(Solutions Below)

Cost of Capital
1. Calculate the cost of equity if stock in a firm has a beta of 1.15. The
market risk premium is 8 percent, and T-bills are currently yielding 4
percent.

2. A bank has an issue of preferred stock with a $6 stated dividend

that just sold for $92 per share. What is the bank's cost of preferred
stock?

3. A firm is trying to determine its cost of debt. The firm has a debt issue
outstanding with 12 years to maturity that is quoted at 105 percent
of its face value of $1,000. The issue makes semiannual payments
and has an coupon rate of 8 percent annually. What is the pretax
cost of debt? If the tax rate is 35 percent, what is the after-tax cost
of debt?

4. A firm has a target capital structure of 50 percent common stock, 5

percent preferred stock, and 45 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. What is its
WACC?

Decision Rules
If r = 10%, determine whether or not to do the following projects
(questions 5-9) using each of the five decision criteria:

 Payback Period (3 year)

 Discounted Payback Period (3 year)
 Net Present Value (NPV) Rule
  Internal Rate of Return (IRR)
 Modified Internal Rate of Return (MIRR) (rRI = 10%)

5.
0 1 2 3 4
-1,000 500 200 200 500

6.
0 1 2 3 4
-10,000 3,500 3,200 3,200 2,500

7.
0 1 2 3 4
-300 250 150 -200 150

8.
0 1 2 3 4
-15,000 5,000 3,000 4,000 5,000

9.

0 1 2 3 4
-10,000 1,600 3,600 1,700 4,500

10. Use the NPV rule to decide on the better project (r = 10%).

0 1 2 3 4
-10,000 3,600 3,100 2,500 4,700
-20,000 8,300 4,900 5,200 7,200
 Solutions
NOTE: I include the formulae solutions but you only need to know how to
do this on a financial calculator.

Cost of Capital
1. Calculate the cost of equity if stock in a firm has a beta of 1.15. The
market risk premium is 8 percent, and T-bills are currently yielding 4
percent.

Using the CAPM, we find:

RE = .04 + 1.15(.08) = .1320 or 13.20%

2. A bank has an issue of preferred stock with a $6 stated dividend

that just sold for $92 per share. What is the bank's cost of preferred
stock?

The cost of preferred stock is the dividend payment divided by the

price, so:

RP = $6/$92 = .0652 or 6.52%

3. A firm is trying to determine its cost of debt. The firm has a debt issue
outstanding with 12 years to maturity that is quoted at 105 percent
of face value. The issue makes semiannual payments and has an
coupon rate of 8 percent annually. What is the pretax cost of debt?
If the tax rate is 35 percent, what is the after-tax cost of debt?

P/Y = 2; N = 24; I/Y = 7.37%;

PV = 1,050; PMT = -40; FV = -1,000
PMT = (1,000 x 0.08)/2 = 40
N = 12 x 2 = 24

And the after-tax cost of debt is:

rD = 0.0737(1 – 0.35) = 0.0479 or 4.79%

4. A firm has a target capital structure of 50 percent common stock, 5

percent preferred stock, and 45 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. What is its
WACC?
 Using the equation to calculate the WACC, we find:

WACC = 0.50(0.16) + 0.05(0.075) + 0.45(0.09)(1 – 0.35)

= 0.1101 or 11.01%

Decision Rules
If r = 10%, determine whether or not to do the following projects
(questions 5-9) using each of the five decision criteria:

a. Payback Period (3 year)

b. Discounted Payback Period (3 year)
c. Net Present Value (NPV) Rule
d. Internal Rate of Return (IRR)
e. Modified Internal Rate of Return (MIRR) (rRI = 10%)

NOTE: Where applicable, You may also use the financial calculator
functions to sole these problems.

5.
0 1 2 3 4
-1,000 500 200 200 500

a. Payback Period (3 year)

Payback  500  200  200  900  1,000

Decision  Bad Project

b. Discounted Payback Period (3 year)

500 200 200

Discounted Payback     770.10  1,000
1.10 1.10  1.10 3
2

Decision  Bad Project

c. Net Present Value (NPV) Rule

500 200 200 500

NPV  1,000      $111.60
1.10 1.10  2
   
1.10
3
1.10
4

$110.60 > 0
Decision  Good Project
 d. Internal Rate of Return (IRR)

500 200 200 500

1,000     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4

 IRR  15.17%  10%

Decision  Good Project

e. Modified Internal Rate of Return (MIRR)

500(1.10)3  200(1.10)2  200(1.10)  500

1,000  0
1  MIRR 
4

 MIRR  12.95%  10%

Decision  Good Project

6.
0 1 2 3 4
-10,000 3,500 3,200 3,200 2,500

a. Payback Period (3 year)

Payback  3,500  3,200  3,200  9,900  10,000

Decision  Bad Project

b. Discounted Payback Period (3 year)

3,500 3,200 3,200

Discounted Payback     8,230.65  10,000
1.10 1.10  1.10 3
2

Decision  Bad Project

c. Net Present Value (NPV) Rule

3,500 3,200 3,200 2,500

NPV  10,000      -$61.81
1.10 1.10  2
1.10  1.10 
3 4

-$61.81 < 0
Decision  Bad Project

d. Internal Rate of Return (IRR)

 3,500 3,200 3,200 2,500
10,000     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4

 IRR  9.70%  10%

Decision  Bad Project

e. Modified Internal Rate of Return (MIRR)

3,500(1.10)3  3,200(1.10)2  3,200(1.10)  2,500

10,000  0
1  MIRR 
4

 MIRR  9.83%  10%

Decision  Bad Project

7.
0 1 2 3 4
-300 250 150 -200 150

a. Payback Period (3 year)

Payback  250  150  200  200  300

Decision  Bad Project

b. Discounted Payback Period (3 year)

250 150 200
Discounted Payback     200.98  300
1.10 1.10  1.10 3
2

Decision  Bad Project

c. Net Present Value (NPV) Rule

250 150 200 150

NPV  300      $3.43
1.10 1.10  2
1.10  1.10 
3 4

$3.43 > 0
Decision  Good Project

d. Internal Rate of Return (IRR)

250 150 200 150

300     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4

 IRR  10.88%  10%

Decision  Good Project
 e. Modified Internal Rate of Return (MIRR)

250(1.10)3  150(1.10)2  200(1.10)  150

300  0
1  MIRR 
4

 MIRR  10.21%  10%

Decision  Good Project

8.
0 1 2 3 4
-15,000 5,000 3,000 4,000 5,000

a. Payback Period (3 year)

Payback  5,000  3,000  4,000  12,000  15,000

Decision  Bad Project

b. Discounted Payback Period (3 year)

5,000 3,000 4,000

Discounted Payback     10.030.05  15,000
1.10 1.10  1.10 3
2

Decision  Bad Project

c. Net Present Value (NPV) Rule

5,000 3,000 4,000 5,000

NPV  15,000      -$1,554.88
1.10 1.10  2
1.10  1.10 
3 4

-$1,554.88 < 0
Decision  Bad Project

d. Internal Rate of Return (IRR)

5,000 3,000 4,000 5,000
15,000     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4

 IRR  5.15%  10%

Decision  Bad Project

e. Modified Internal Rate of Return (MIRR)

 5,000(1.10)3  3,000(1.10)2  4,000(1.10)  5,000
15,000  0
1  MIRR 
4

 MIRR  7.03%  10%

Decision  Bad Project

9.

0 1 2 3 4
-10,000 1,600 3,600 1,700 4,500

a. Payback Period (3 year)

Payback  1,600  3,600  1,700  6,900  10,000

Decision  Bad Project

b. Discounted Payback Period (3 year)

1,600 3,600 1,700

Discounted Payback     5,706.99  10,000
1.10 1.10  1.10 3
2

Decision  Bad Project

c. Net Present Value (NPV) Rule

1,600 3,600 1,700 4,500

NPV  10,000      -$1,219.45
1.10 1.10  2
   
1.10
3
1.10
4

-$1,219.45 < 0
Decision  Bad Project

d. Internal Rate of Return (IRR)

1,600 3,600 3,600 1,700
10,000     0
1  IRR 1  IRR  2
1  IRR  1  IRR 
3 4

 IRR  4.85%  10%

Decision  Bad Project

e. Modified Internal Rate of Return (MIRR)

 1,600(1.10)3  3,600(1.10)2  3,600(1.10)  1,700
10,000  0
1  MIRR 
4

 MIRR  6.48%  10%

Decision  Bad Project

10. Use the NPV rule to decide on the better project (r = 10%).

0 1 2 3 4
-10,000 3,600 3,100 2,500 4,700
-20,000 8,300 4,900 5,200 7,200

3,600 3,100 2,500 4,700

NPV  10,000      $923.16
1.10 1.10  2
   
1.10
3
1.10
4

8,300 4,900 5,200 7,200

NPV  20,000      $418.58
1.10 1.10  2
1.10  1.10 
3 4

$923.16 > $418.58

Decision  Do the First Project