Practice Questions-Week 8
Chapter Name: Cost of Capital
Q.1 A company finances its operations with 40 percent debt and 60 percent equity. Its net income is I =
$16 million and it has a dividend payout ratio of x = 25%. Its capital budget is B = $15 million this year.
The annual yield on the company’s debt is rd = 10% and the company’s tax rate is T = 30%. The
company’s common stock trades at P0 = $55 per share, and its current dividend of D0 = $5 per share is
expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if it is issued,
is F = 5% of the dollar amount issued. What is the company’s WACC?
Q.2 A company finances its operations with 40 percent debt and 60 percent equity. Its net income is I =
$16 million and it has a dividend payout ratio of x = 25%. Its capital budget is B = $15 million this year.
The annual yield on the company’s debt is rd = 10% and the company’s tax rate is T = 30%.
The company’s common stock trades at Po = $55 per share, and its current dividend of D0 = $5 per share
is expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if it is
issued, is F = 5% of the dollar amount issued. What is the company’s WACC?
Now the company is planning to expand its operations. The managing director has proposed two
investments alternative Project X and Y. Below are the cash flows for two mutually exclusive projects.
year CFX CFY
0 (5 m) (5 m)
1 2.085m 0
2 2.085m 0
3 2.085m 0
4 2.085m 9.677m
On the basis of MIRR, evaluate which project is more feasible?
Q.3 A firm is considering a new project which would be similar in terms of risk to its existing projects.
The firm needs a discount rate for evaluation purposes. The firm has enough cash on hand to provide the
necessary equity financing for the project. Also, the firm:
- has 1,000,000 common shares outstanding
- current price $11.25 per share
- next year’s dividend expected to be $1 per share
- firm estimates dividends will grow at 5% per year after that
- flotation costs for new shares would be $0.10 per share
- has 150,000 preferred shares outstanding
- current price is $9.50 per share
- dividend is $0.95 per share
- if new preferred are issued, they must be sold at 5% less than the current market
price (to ensure they sell) and involve direct flotation costs of $0.25 per share
- has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds
with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently,
the bonds sell at 106% of par value. Flotation costs for new bonds would equal 6% of par
value.
The firm’s tax rate is 40%. What is the appropriate discount rate for the new project?
Q.4 Given the following information, what is the WACC for the following firm?
Debt: 9,000 bonds with a par value of $1,000 and a quoted price of 1126.5. The bonds have
coupon rate of 7 percent and 28 years to maturity.
Preferred Stock: 20,000 shares of 3.5 percent preferred selling at a price of $65.
Common Stock: 400,000 shares of stock selling at a market price of $48. The beta of the stock is 0.9. The
stock just paid a dividend of $2.10 per share and the dividends are expected to grow at 6
percent per year indefinitely.
Market: The expected return on the market is 14 percent and the risk-free rate is 3.5 percent. The
company is in the 38 percent tax bracket.
Q.5 The Perkins Company has employed you to analyze a capital project. It has given you the following
information:
Bond Coupon Rate Price Maturity Number of Bonds Outstanding
Quote
1 6.75 955 22 35,000
2 7.25 1100 20 45,000
The bonds make semiannual interest payments and the marginal tax rate is 40 percent. Perkins expects
the next dividend (D1) to be $0.45 and its common stock is currently selling for $5.625 per share. The
expected growth rate in earnings and dividends is a constant 5%. Perkins has a beta of 1.3, the risk-free
rate is 3 percent, and the expected market return is 12.5 percent. Perkins has 25,000,000 shares of
common stock outstanding.
To complete the analysis, the NPV and IRR need to be calculated for the project. The initial investment is
$22.2 million. The net cash flows are $6 million for years one through four and $8 million for year five.
Should Perkins accept this project?
