Scribd
Upload
64 views

Week 12 Unit 10 Tutorial Questions

Uploaded by

tanning zhu
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
64 views

Week 12 Unit 10 Tutorial Questions

Uploaded by

tanning zhu
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 3

Chapter 11 - Calculating the Cost of Capital

Week 12 Unit 10

CHAPTER 11 – CALCULATING THE COST OF CAPITAL

Questions

LG3 3. Under what situations would you want to use the CAPM approach for estimating the
component cost of equity? The constant-growth model?

Not appropriate when historical data is insufficient e.g. the stock is fairly new, or not a
good indicator of future or the firm changes its operations or expands into a new business
in which the firm’s risk level has changed. Otherwise, CAPM is more popular.

If the company’s stock is expected to experience constant dividend growth.

LG4 5. Why do we use market-based weights instead of book-value-based weights when


computing the WACC?

Because we focus on determining the cost of financing a company’s asset base on current
market conditions and the component costs the company is currently facing, not historical
data.

Problems

LG3 11-1 Cost of Equity Diddy Corp. stock has a beta of 1.2, the current risk-free rate is 5 percent,
and the expected return on the market is 13.5 percent. What is Diddy’s cost of equity?

iE= rf+β(rM-rf)=5%+1.2×(13.5%-5%)=0.152

LG3 11-2 Cost of Debt KatyDid Clothes has a $150 million (face value) 30-year bond issue selling
for 104 percent of par that carries a coupon rate of 11 percent, paid semiannually. What
would be Katydid’s before-tax component cost of debt?

PV=-1040, FV=1000, N=60, PMT=55, I=5.28

LG3 11-3 Cost of Preferred Stock Marme, Inc. has preferred stock selling for 96 percent of par
that pays an 11 percent annual coupon. What would be Marme’s component cost of
preferred stock?

ip= D1/P0=11%/96%=0.115

11-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Chapter 11 - Calculating the Cost of Capital

LG3 11-4 WACC Johnny Cake Ltd. has 10 million shares of stock outstanding selling at $23 per
share and an issue of $50 million in 9 percent, annual coupon bonds with a maturity of
17 years, selling at 93.5 percent of par. If Johnny Cake’s weighted average tax rate is 34
percent, its next dividend is expected to be $3 per share, and all future dividends are
expected to grow at 6 percent per year, indefinitely, what is its WACC?

1. PV= -935, PMT=90, FV=1000, N= 17, I=9.80%

2. Cost of equity=D1/P0+g= $3/$23+5%=0.18

3. Weights: total value= (10,000,000 × 23) +  (50,000,000 × 0.935) = 276,750,000

Common stock= (10,000,000 × $23)/276,750,000 =0.831

Preferred stock=0

Bonds=(50,000,000 × 0.935)/276,750,000 =0.169

WACC=(0.831×0.18) +(0.169×0.098×[1-0.34])=0.161

LG6 11-5 Firmwide vs. Project-Specific WACCs An all-equity firm is considering the projects
shown as follows. The T-bill rate is 4 percent and the market risk premium is 7 percent.
If the firm uses its current WACC of 12 percent to evaluate these projects, which
project(s), if any, will be incorrectly accepted?

Project Expecte Beta


d Return
A 8.0% 0.5
B 19.0 1.2
C 13.0 1.4
D 17.0 1.6

Project A: iE= rf+β(rM-rf)=4%+0.5×7%=7.5%

Project B: iE= rf+β(rM-rf)=4%+1.2×7%=12.4%

Project C : iE= rf+β(rM-rf)=4%+1.4×7%=13.8%

Project D : iE= rf+β(rM-rf)=4%+1.6×7%=15.2%

The expected return of project C is 13%, but the result of calculation is 13.8%. Therefore,
project C will be incorrectly accepted

11-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.
Chapter 11 - Calculating the Cost of Capital

LG7 11-6 Divisional WACCs Suppose your firm has decided to use a divisional WACC approach
to analyze projects. The firm currently has four divisions, A through D, with average
betas for each division of 0.9, 1.1, 1.3, and 1.5, respectively. If all current and future
projects will be financed with 25 percent debt and 75 percent equity, and if the current
cost of equity (based on an average firm beta of 1.2 and a current risk-free rate of 4
percent) is 12 percent and the after-tax yield on the company’s bonds is 9 percent, what
will the WACCs be for each division?

iE= rf+β(rM-rf)

13%=7%+10[(rM -7%)]

13%= rM

Division A: iE= rf+β(rM-rf)=7%+0.6*（13%-7%）=10.6%

Division B: iE= rf+β(rM-rf)=7%+1.0*（13%-7%）=13%

Division C: iE= rf+β(rM-rf)=7%+1.3*（13%-7%）=14.8%

Division D: iE= rf+β(rM-rf)=7%+1.6*（13%-7%）=16.6%

E D
WACCs: WACC= iE + iD∗( 1−Tc )
E+ P+ D E+ P+ D

Division A: WACC¿ 9.3 %

Division B: WACC=10.5 %

Division C: WACC¿ 11.4 %

Division D: WACC¿12.3%

11-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.

You might also like