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  • The company has a target capital structure of 40% debt and 60% equity.
  • Bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54.
  • The company stock beta is 1.2.
  • Risk-free rate is 10%, and market risk premium is 5%.
  • The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.
  • The company's marginal tax rate is 40%.
The after-tax cost of debt is:
A)
8.0%.
B)
7.2%.
C)
9.1%.



N = 40; PMT = 50; FV = 1,000; PV = 849.54; Compute i = 6%, double = 12%, now (12)(1 − 0.4) = 7.2%.

The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash flow approach is:
CAPMDiscounted Cash Flow
A)
16.0%16.0%
B)
16.0%15.4%
C)
16.6%15.4%


CAPM = 10 + (5)(1.2) = 16%.
Discounted Cash Flow: D1 = 2(1.08) = 2.16, now (2.16 / 27) + 0.08 = 16%

TOP

A company has the following data associated with it:
  • A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
  • Outstanding 20-year annual pay 6% coupon bonds selling for $894.
  • Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2 dividend one year from today.
  • Their $100 par preferred stock currently sells for $90 and is earning 5%.
  • The company's tax rate is 40%.
What is the after tax cost of debt capital and after tax cost of preferred stock capital?

Debt CapitalPreferred Stock Capital
A)
4.2%6.3%
B)
4.5%5.6%
C)
4.2%5.6%



Debt
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT → I = 7%
kd = (7%)(1 − 0.4) = 4.2%
Preferred Stock
kps = Dps / P
kps = 5 / 90 = 5.56%


What is the weighted average cost of capital (WACC)?
A)
9.2%.
B)
10.3%.
C)
8.5%.



kce = (D1 / P0) + g
kce = 2 / 45 + 0.08 = 0.1244 = 12.44%
WACC = (0.4)(4.2) + (0.1)(5.6) + (0.5)(12.4) = 8.5%

TOP

A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume annual payments). The bonds trade at a price of $92 per $100 par in the open market. The firm’s marginal tax rate is 35%. What is the after-tax component cost of debt to be used in the weighted average cost of capital (WACC) calculations?
A)
6.02%.
B)
9.26%.
C)
5.40%.



If the bonds are trading at $92 per $100 par, the required yield is 9.26%, and the market value of the issue is $2.76 million.
The equivalent after-tax cost of this financing is: 9.26% (1 – 0.35) = 6.02%.

TOP

Genoa Corp. is estimating its weighted average cost of capital (WACC). They have several pieces of data to consider. The firm pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year’s earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. Genoa's 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%.The cost of common equity is closest to:
A)
13.76%.
B)
16.14%.
C)
14.19%.


ROE × retention ratio = growth rate.
15% × (1 – 0.40) = 9%
D0 = $5.00 × 0.40 = $2.00
[$2.00(1.09) / $42.00] + 0.09 = 14.19%


The after-tax cost of debt is closest to:
A)
7.5%.
B)
5.3%.
C)
5.6%.



7.5 × (1 − 0.3) = 5.25%

TOP

Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest to:
Debt Preferred stock
A)
10.0% 7.6%
B)
6.0% 12.7%
C)
6.0% 7.6%



After-tax cost of debt = 10% × (1 – 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.

TOP

If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?
A)
Both decrease.
B)
One increase and one decrease.
C)
Both increase.



An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.

TOP

The following information applies to a corporation:
  • The company has $200 million of equity and $100 million of debt.
  • The company recently issued bonds at 9%.
  • The corporate tax rate is 30%.
  • The company's beta is 1.125.

If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company’s after-tax weighted average cost of capital is closest to:
A)
12.1%.
B)
10.5%.
C)
11.2%.



ks = RFR + β(Rm − RFR)
= 6% + 1.125(14% − 6%) = 15%
WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks
= (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1%

TOP

A company’s outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of 40%, the company’s after-tax cost of debt capital is closest to:
A)
4.2%.
B)
5.1%
C)
7.0%


Pretax cost of debt: N = 20; FV = 1000; PV = −894; PMT = 60; CPT → I/Y = 7%
After-tax cost of debt: kd = (7%)(1−0.4) = 4.2%

TOP

Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating Degen’s project is closest to:
A)
8.9%.
B)
8.6%.
C)
9.2%.



Hodgkins’ asset beta:

We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.
Equity beta for the project:
βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932
Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%
Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%.
The appropriate WACC for the project is therefore:
0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.

TOP

Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian’s weighted average cost of capital for this potential expansion.
A)
5.7%.
B)
4.2%.
C)
7.1%.



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