Cost of Capital

Question Bank
1. Which of the following factors affecting the cost of capital can be controlled by the firm?
a. Tax rates
b. Dividend policy
c. Level of interest rates
d. All of the above
Answer: b

2. Which of the following is an uncontrollable factor that affects a firm’s capital cost?

a. Capital structure policy

b. Debt service charges
c. Investment policy
d. None of the above
Answer: d

3. G PLC issued Rs200, 15% debentures, and these debentures traded at a price of Rs250, if
tax rate of the company is 40%, What is the cost of debt
a. 12%
b. 11.25%
c. 9%
d. 7.2%
Answer: d

4. Aqua Ltd has preferred stock that sells for Rs200 per share and pays an annual dividend of
Rs 25 If the flotation costs is 5% from selling price. What is the cost of preferred stock?
a. 13.16%
b. 12.5%
c. 12.11%
d. 11.88%
Answer: a

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5. Zinco limited common stock is currently selling for Rs45 per share. Its present dividend
D0 is Rs0.5 per share, and the expected long-term dividend growth rate is 9%. Transaction
cost related to issue of new shares is 5% from issued shares. Par value of a share is Rs.10.
What is the external cost of capital?
a. 10.21%
b. 10.16%
c. 10.27%
d. 10.11%
Answer: c

6. Zinco limited common stock is currently selling for Rs45 per share. Its present dividend
D0 is Rs0.5 per share, and the expected long-term dividend growth rate is 9%. Transaction
cost related to issue of new shares is 5% from issued shares. Par value of a share is Rs.10.
What is the internal cost of capital?
a. 10.21%
b. 10.16%
c. 10.27%
d. 10.11%
Answer: a.

7. The CAPM formula for calculating the cost of equity is:

a. Cost of Equity = Risk-free rate + Beta * Market Risk Premium
b. Cost of Equity = Risk-free rate + Market Risk Premium / Beta
c. Cost of Equity = Risk-free rate / Beta + Market Risk Premium
d. Cost of Equity = Risk-free rate * Beta + Market Risk Premium
Answer: a

8. ABC PLC’s common stock has a beta of 0.90, while XYZ PLC’s common stock has a beta
of 1.80. The expected return on the market is 10 percent, and the risk-free rate is 6 percent.
According to the capital-asset pricing model (CAPM), cost of equity of ABC PLC’s and
XYZ PLC’s are,

a. 3.6% and 7.2%

b. 9.6% and 13.2%
c. 9 and 18%
d. 14% and 23%
Answer: b

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9. The NuPress Valet Co. has an improved version of its hotel stand. The investment cost is
expected to be Rs72 million and will return Rs13.5 million for 5 years in net cash flows. The
ratio of debt to equity is 1 to 1. The cost of equity is 13%, the cost of debt is 9%, and the tax rate
is 34%. The appropriate discount rate, assuming average risk, is:
a. 8.65%
b. 9%
c. 9.47%
d. 10.5% e. 13%
Answer: c

10. What is the weighted average cost of capital in the following situation?
The firm has Rs.40 million in long-term debt, Rs.8 million in preferred stock, and Rs.32
million in common equity at market values. The before-tax cost for debt, preferred stock,
and common equity forms of capital are 8%, 9%, and 15%, respectively. Assume a 40%
tax rate.
a. 6.54%
b. 9.30%
c. 10.9%
d. 6.4%
Answer : b

11) Suppose Azman Enterprise can raise capital by issuing bonds with a face value of Rs.1000, a
coupon rate of 5% and a 10 years to maturity at 980 per bond. If its corporate tax rate is 30%,
what is the cost of debt?
Solution: You know the approximate cost of debt before tax is:
Kd = CP + (Maturity value – Net proceeds)/ n
(Net proceeds + Maturity value)/2

So, Kd = 50 + (1000 – 980)/10

(980 + 1000)/2
= 5.20%
So, after-tax cost of debt would be approximately, 5.20% (1-.30) = 3.64%.

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12) Vextex is thinking of issuing a 15% stated dividend preferred stock that is expected to sell
for Rs.65 per share and has a Rs. 5 floatation cost. What is the cost of Vextex’s preferred stock?
Solution:
The cost of preferred stock Kp = Dp/Np.
Here for Vextex’s cost of preferred stock, Kp = 9.75/(65-5) = 16.25%.

13) If a firm is expected to pay Rs.2 dividend in the next period and it is expected to grow at 3
percent per period and the share price is Rs.28.57 then what is the required rate of return on
common stock using dividend growth model?
Solution:
Ke = D1 + g
P0
Ke = 2/28.57 + 0.03 = 0.1 or 10% is the cost of equity.

14) ABC company paid Rs.2 cash dividend last year and is expected to increase the dividend by
5 percent next year whereas the current market price of ABC’s common stock is Rs.25. What is
the cost of equity on ABC using dividend growth model?
Solution:
Given: P0 = Rs.25; D0 = Rs.2; and g = 5%

Ke = D0(1+g) + g
P0
Ke = 2(1+0.05) + 0.05
25
= 0.134 or 13.4%.

15) Suppose the risk free rate is 14 percent and the cost of equity is 21.2% and the beta of this firm
is 1.8. What was the expected return from the market?

Solution: Ke = Krf + β (Km - Krf).

Or, 21.2% = 14% + 1.8(Km - 14%)
Or, 1.8Km = 21.2% - 14% + 25.2%
So, Km = 18%.

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16) ABC company has the following financing outstanding:

Debt: 50,000 bonds with an 8% coupon rate and a quoted price of 119.8% of par value of Rs.1000;
the bonds have 15 years to maturity.
Preferred Stock: 120,000 shares of 6.5% preferred with a current price of Rs.112, and a par value
of Rs.100.
Common stock: 2,000,000 shares of common stock at a Rs.10 par value, the current price is Rs.65,
and the beta of the stock is 1.1.
Market: The corporate tax rate is 40%, the market risk premium is 9%, and the risk-free rate is 4%.
What is the WACC for the company?

Solution:
You will begin by finding the market value (MV) of each type of financing. You will use D 1 to
represent the coupon bond, P for preferred and E for common stock. So, the market value of the
firm’s financing is:

MVD1 = 50,000(1,000)(1.1980) = Rs. 59,900,000

MVP = 120,000(112) = Rs.13,440,000
MVE = 2,000,000(65) = Rs.130,000,000

And the total market value of the firm is:

V = 59,900,000 + 13,440,000 + 130,000,000 = Rs.203,340,000

Now, you can find the cost of equity using the CAPM. The cost of equity is:
= .04 + 1.10(.09) = .1390 or 13.90%

The cost of debt is the YTM of the bonds, so:

Approximate YTM = 80 + (1000 – 1198)/15
(1000+1198)/2
= 6.07%.

And the after-tax cost of debt is:

kd = (1 – .40)(.0607) = .0364 or 3.64%
To find the required return on preferred stock, we can use the preferred stock pricing equation,
which is the level perpetuity equation, so the required return on the company’s preferred stock is:
kp = D1 / P0
kp = 6.50 / 112 = .0580 or 5.80%.

So plugging the numbers in the WACC equation you get:

59,900,000 13,440,000 130,000,000

WACC = (0.364) + (0.058) + (0.139)
203,340,000 203,340,000 203,340,000

So, WACC = 10.34%