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CHAPTER 11 Without Answer

The document provides information on calculating a firm's weighted average cost of capital (WACC) given different capital structures and costs of debt, preferred stock, and common equity. It includes examples of calculating WACC using both book and market values, as well as calculating WACC and determining the acceptability of investment projects for a firm with varying costs of capital depending on the amount of new financing obtained.

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623 views3 pages

CHAPTER 11 Without Answer

The document provides information on calculating a firm's weighted average cost of capital (WACC) given different capital structures and costs of debt, preferred stock, and common equity. It includes examples of calculating WACC using both book and market values, as well as calculating WACC and determining the acceptability of investment projects for a firm with varying costs of capital depending on the amount of new financing obtained.

Uploaded by

lenaka
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd
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CHAPTER 11

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

Target Market
Source of Capital Proportions
Long-term debt 30%
Preferred stock 5
Common stock equity 65

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.

2. Promo Pak has compiled the following financial data:

Source of Capital Book Value Market Value Cost


Long-term debt $10,000,000 $8,500,000 5.0%
Preferred stock 1,000,000 1,500,000 14.0
Common stock equity 9,000,000 15,000,000 20.0
$20,000,000 $25,000,000

(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.
Chapter 11 The Cost of Capital  438

North Sea Oil has compiled the following data relative to current costs of its basic sources of external
capital—long-term debt, preferred stock, and common stock equity—for variant ranges of financing.
Table 11.4
Source of Capital Cost Range of Total New Financing
Long-term debt 7% $0–$2,000,000
8 $2,000,001–$3,000,000
10 $3,000,001 and above
Preferred stock 19% $0–$ 960,000
21 $960,001 and above
Common stock 20% $0–$ 700,000
24 $700,001–$1,600,000
26 $1,600,001–$2,200,000
30 $2,200,001 and above

The firm expects to have $350,000 of current retained earnings in the coming year at a cost of 20 percent;
once these retained earnings are exhausted, the firm will issue new common stock. The company’s target
capital structure proportions are used in calculating the weighted average cost of capital follow.

Source of Capital Target Capital Structure


Long-term debt 0.25
Preferred stock 0.25
Common stock equity 0.50
Chapter 11 The Cost of Capital  439

3. Calculate the firm’s cost of capital prior to exhausting the firm’s available current retained earnings.
(See Table 11.4.)

4. Calculate the firm’s cost of capital for $2,000,000 of total new financing. (See Table 11.4.)

5. Given the following information on the available investment opportunities below, determine which
projects should be selected. (See Table 11.4.)

Investment Initial Internal Rate


Opportunity Investment of Return
A 400,000 22%
B 500,000 21
C 400,000 19
D 400,000 17
E 600,000 16
F 700,000 16

6. A corporation is considering a capital project for the coming year.


The project has an internal rate of return of 14 percent. If the firm has the following target
capital structure and costs, what should their decision be and why?
Source of Capital Proportion After-Tax Cost
Long-term debt 0.40 10%
Preferred stock 0.10 15%
Common stock equity 0.50 20%

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