Part 1: Final Review Questions

1. A firm has determined its optimal capital structure, which is composed of the following sources and
target market value proportions:

Debt: The firm can sell a 20-year, $1,000 par value, 9 percent bond for $980. A flotation cost of 2 percent of
the face value would be required in addition to the discount of $20.

Preferred Stock: The firm has determined it can issue preferred stock at $65 per share par value. The stock
will pay an $8.00 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: The firm's common stock is currently selling for $40 per share. The dividend expected to be
paid at the end of the coming year is $5.07. Its dividend payments have been growing at a constant rate for
the last five years. Five years ago, the dividend was $3.45. It is expected that to sell, a new common stock
issue must be underpriced at $1 per share and the firm must pay $1 per share in flotation costs.
Additionally, the firm's marginal tax rate is 40 percent.

Calculate the firm's weighted average cost of capital assuming the firm has exhausted all retained earnings.

Answer:

Interest on debt = $1,000 × 9% = $90

Net proceeds = $1,000 - $20 - ($1,000 × 2%) = $960
Before-tax cost of debt = 9.45% (using financial calculator)
ri = 9.45% × (1-40%) = 5.67%

rp = $8 ÷ ($65 - $3) = 12.9%

Growth = (($5.07 - $3.45) ÷ $3.45) × 100 = 47% ÷ 5 years = 9.3913%

Net proceeds = $40 - 1 - 1 = $38
rn = ($5.07 ÷ $38) + 9.3913% = 22.73%

ra = (0.3) × ($5.67) + (0.05) × (12.9) + (0.65) × (22.73) = 16.20%

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 2. A firm has determined its optimal capital structure which is composed of the following sources and
target market value proportions.

Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2% of the
face value would be required in addition to the discount of $40.

Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock
will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share.

Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be
paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for
the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock
issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40
percent.

1. The firm's before-tax cost of debt is ________.

A) 7.8 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent

Answer: A

2. The firm's after-tax cost of debt is ________.

A) 3.25 percent
B) 4.67 percent
C) 8 percent
D) 8.13 percent

Answer: B

3. The firm's cost of preferred stock is ________.

A) 7.2 percent
B) 8.3 percent
C) 13.3 percent
D) 13.9 percent

Answer: D

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 4. The firm's cost of a new issue of common stock is ________.
A) 7 percent
B) 9.08 percent
C) 14.2 percent
D) 13.4 percent

Answer: C

5. The firm's cost of retained earnings is ________.

A) 10.2 percent
B) 13.9 percent
C) 13.7 percent
D) 13.6 percent

Answer: C

6. The weighted average cost of capital up to the point when retained earnings are exhausted is ________.
A) 7.5 percent
B) 8.65 percent
C) 10.4 percent
D) 11.9 percent

Answer: D

7. If the target market proportion is reduced to 15 percent, what will be the revised weighted average cost
of capital?
A) 13.6 percent
B) 11.0 percent
C) 12.34 percent
D) 10.4 percent

Answer: C

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 Part 2: End of Chapter Questions

1. Brigham Jewellery Corporation common stock has a beta (b) of 1.8, the risk-free rate is 5%, and the
market return is 16%.

a. Determine the risk premium on Brigham common stock.

b. Determine the required return that Brigham common stock should provide.
c. Determine Brigham’s cost of common stock equity using the CAPM

Answer:

Rs =RF+ [b (Rm -RF)]

Rs =5% + 1.8  (16% -5%)
Rs =5% + 19.8%
Rs = 24.8%

Where: Rs = Required Return on Stock

B = Stock’s Beta
Rm = Market Return
Rf = Risk-free Rate

a. Risk premium =19.8%

b. Rate of return =24.8%
c. Cost of common equity using the CAPM =24.8%

2. Smart Finance Corporation wishes to explore the effect on its cost of capital of the rate at which the
company pays taxes. The company wishes to maintain a capital structure of: 30% debt, 10% preferred
stock, and 60% common stock.
The cost of financing with equity is 12%, the cost of preferred stock financing is 7%, and the before-tax
cost of debt financing is 5%.
Calculate the weighted average cost of capital (WACC) given the tax rate is:
a. Tax rate 5.50%
b. Tax rate 5.40%

Answer:

a.WACC = (0.30)(5%)(1 - 0.50) + (0.10)(7%) + (0.60)(12%)

WACC =0.75% + 0.7% +7.2%
WACC =8.65%

b.WACC = (0.30)(5%)(1 - 0.40) + (0.10)(7%) + (0.60)(12%)

WACC =0.9% + 0.7% +7.2%
WACC =8.8%

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 NOTE THAT: As the tax rate falls, the WACC increases due to the reduced tax-shield from the tax-
deductible interest on debt.

3. Edna Recording Studios, Inc., reported earnings available to common stock of $4,200,000 last year. From
those earnings, the company paid a dividend of $1.26 on each of its 1,000,000 common shares
outstanding. The capital structure of the company includes 40% debt, 10% preferred stock, and 50%
common stock. It is taxed at a rate of 40%.

a. If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6%
per year for the foreseeable future, what is the company’s cost of retained earnings financing?

b. If underpricing and flotation costs on new shares of common stock amount to $7.00 per share, what
is the company’s cost of new common stock financing?

c. The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share.
Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

d. The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200
each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the
approximate cost of debt financing.

e. What is the WACC?

Answer:

a. Cost of retained earnings

$1.26(1  0.06) $1.34

rr   0.06   3.35%  6%  9.35%
$40.00 $40.00

b. Cost of new common stock

$1.26(1  0.06) $1.34

rs   0.06   4.06%  6%  10.06%
$40.00  $7.00 $33.00

c. Cost of preferred stock

$2.00 $2.00
rp    9.09%
$25.00  $3.00 $22.00

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 d.

$1,000  $1,175
$100 
5 $65.00
rd    5.98%
$1,175  $1,000 $1,087.50
2

ri = 5.98%  (1 - 0.40) = 3.59%

e. WACC = (0.40)(3.59%) + (0.10)(9.09%) + (0.50)(9.35%)

WACC = 1.436 + 0.909 + 4.675

WACC = 7.02%

4. Peter Chan has just acquired three houses by obtaining three mortgage loans. They all mature in 15
years and can be repaid without penalty any time before maturity. The amounts owed and the annual
interest rate associated with each mortgage loan are given in the following table:

Mortgage Balance due Annual

loan interest rate

A $520,000 8%

B $92,000 12%

C $832,000 6%

Peter can also combine the total of his three loans (that is, $1,444,000) and create a consolidated loan
from his wife. His wife will charge a 6.8% annual interest rate for a period of 15 years. Should Peter do
nothing (leave the three individual loans as they are) or create a consolidated loan of $1,444,000?

Answer:

Rate Outstanding Loan Balance Weight WACC

[1] [2] [2] 1,444,000 = [1]  [3]
[3]

Loan A 8% $ 520,000 36.01% 2.88%

Loan B 12% $92,000 6.37% 0.76%

Loan C 6% $832,000 57.62% 3.46%

Total $1,444,000 7.10%

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 Peter Chan should consolidate his three mortgage loans because their weighted cost is more than the
6.8% offered by his wife.

5. Lang Enterprises is interested in measuring its overall cost of capital. Current investigation has gathered
the following data.

The firm is in the 40% tax bracket.

Debt: The firm can raise debt by selling $1,000-par-value, 8% coupon interest rate, 20-year bonds on
which annual interest payments will be made. To sell the issue, an average discount of $30 per bond
would have to be given. The firm also must pay flotation costs of $30 per bond.

Preferred stock: The firm can sell 8% preferred stock at its $95-per-share par value. The cost of issuing
and selling the preferred stock is expected to be $5 per share. Preferred stock can be sold under these
terms.

Common stock: The firm’s common stock is currently selling for $90 per share. The firm expects to pay
cash dividends of $7 per share next year. The firm’s dividends have been growing at an annual rate of
6%, and this growth is expected to continue into the future. The stock must be underpriced by $7 per
share, and flotation costs are expected to amount to $5 per share. The firm can sell new common stock
under these terms.

Retained earnings: When measuring this cost, the firm does not concern itself with the tax bracket or
brokerage fees of owners. It expects to have available $100,000 of retained earnings in the coming year;
once these retained earnings are exhausted, the firm will use new common stock as the form of
common stock equity financing.

Source of capital Weight

Long-term debt 30%
Preferred stock 20%
Common stock equity 50%
Total 100%

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the firm’s weighted average cost of capital

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 Answer:

a. After-tax cost of debt

Approximate approach

($1,000  N d )
I
rd  n
( N d  $1,000)
2

($1,000  $940)
$80 
20 $80  $3
rd    8.56%
($940  $1,000) $970
2

ri = rd  (1 - t)

ri = 8.56%  (1 - 0.40)

ri = 5.14%

Calculator approach

N = 20, PV = $940, PMT = -$80, FV = -$1,000

Solve for I: 8.64%

After-tax cost of debt: 8.64% (1 -0.40) = 5.18%

b. Preferred stock:

Dp
rp 
Np
$7.60
rp   8.44%
$90

c. Retained earnings:

D1
rr  g
P0
= ($7.00 ÷ $90) + 0.06 = 0.0778 + 0.0600 = 0.1378 or 13.78%

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 New common stock:

D1
rn  g
Nn
= [$7.00 ÷ ($90  $7  $5)] + 0.06
= [$7.00 ÷ $78] + 0.06 = 0.0897 + 0.0600 = 0.1497 or 14.97%

Target Cost of
Capital Capital Weighted
Type of Capital Structure % Source Cost

With retained earnings

Long-term debt 0.30 5.18% 1.55%

Preferred stock 0.20 8.44% 1.69%

Common stock equity 0.50 13.78% 6.89%

WACC = 10.13%

With new common stock

Long-term debt 0.30 5.18% 1.55%

Preferred stock 0.20 8.44% 1.69%

Common stock equity 0.50 14.97% 7.48%

WACC = 10.72%

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