FNCE 101: Dr Chiraphol New Chiyachantana

Problem Set # 6 (Chapter 14)

1. Blair Brothers’ stock currently has a price of $50 per share and is expected to pay a year-end dividend of
$2.50 per share (D1 = $2.50). The dividend is expected to grow at a constant rate of 4 percent per year.
The company has insufficient retained earnings to fund capital projects and must, therefore, issue new
common stock. The new stock has an estimated flotation cost of $3 per share. What is the company’s
cost of equity capital? (9.32%)

2. Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent
common equity. The current market price of the firm’s stock is P0 = $28; its last dividend was D0 =
$2.20, and its expected dividend growth rate is 6 percent. What will Allison’s marginal cost of
retained earnings, ks, be? (14.3%)

3. A company just paid a $2.00 per share dividend on its common stock (D0 = $2.00). The dividend is
expected to grow at a constant rate of 7 percent per year. The stock currently sells for $42 a share. If
the company issues additional stock, it must pay its investment banker a flotation cost of $1.00 per
share. What is the cost of external equity, ke? (12.22%)

4. What is the company’s WACC? The company has collected the following information: (9.66%)

• Its capital structure consists of 40 percent debt and 60 percent common equity.
• The company has 20-year bonds outstanding with a 9 percent annual coupon trading at par.
• The company’s tax rate is 40 percent.
• The risk-free rate is 5.5 percent.
• The market risk premium is 5 percent.
• The stock’s beta is 1.4.

5. What is Trojan’s WACC? Trojan Services’ CFO is interested in estimating the company’s WACC and
has collected the following information: (9.89%)

• The company has bonds outstanding that mature in 26 years with an annual coupon of 7.5 percent.
The bonds have a face value of $1,000 and sell in the market today for $920.
• The risk-free rate is 6 percent.
• The market risk premium is 5 percent.
• The stock’s beta is 1.2.
• The company’s tax rate is 40 percent.
• The company’s target capital structure consists of 70 percent equity and 30 percent debt.
• The company uses the CAPM to estimate the cost of equity and does not include flotation costs as
part of its cost of capital.

6. Flaherty Electric has a capital structure that consists of 70 percent equity and 30 percent debt. The company’s
long-term bonds have a before-tax yield to maturity of 8.4 percent. The company uses the DCF approach to
determine the cost of equity. Flaherty’s common stock currently trades at $45 per share. The year-end
dividend (D1) is expected to be $2.50 per share, and the dividend is expected to grow forever at a constant rate
of 7 percent a year. The company estimates that it will have to issue new common stock to help fund this
year’s projects. The flotation cost on new common stock issued is 10 percent, and the company’s tax rate is 40
percent. What is the company’s weighted average cost of capital, WACC? (10.73%)

7. Charlie Co. has 15,000 shares of common stock outstanding at a market price of $21 a share. There are
5,000 shares of 6 percent preferred stock outstanding at a market price of $42 a share. The firm has a
bond issue outstanding with a face value of $200,000 which is selling at 98 percent of face value. The
firm’s tax rate is 34 percent. What weight should be given to the common stock when computing the
weighted average cost of capital for this company? (44%)
8. Bradshaw Steel has a capital structure with 30 percent debt (all long- term bonds) and 70 percent
common equity. The yield to maturity on the company’s long-term bonds is 8 percent, and the firm
estimates that its overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent,
the market risk premium is 5 percent, and the company’s tax rate is 40 percent. Bradshaw uses the
CAPM to determine its cost of equity. What is the beta on Bradshaw’s stock? (1.35)

9. SunDry Company has shares of preferred stock outstanding. The current preferred stock price is $80
per share and the company pays preferred stock dividends of $6 per share. If the growth rate in the
economy is expected to remain at a constant rate of 3%, what is the market rate of return for the
preferred stock? (7.5%)

10. Intel Co. has a capital structure with 30 percent debt (all long- term bonds) and 70 percent common
equity. The yield to maturity on the company’s long-term bonds is 8 percent, and the firm estimates
that its overall composite WACC is 10 percent. The risk-free rate of interest is 5.5 percent, the market
risk premium is 5 percent, and the company’s tax rate is 40 percent. What is the beta on Intel’s stock?
(1.35)

11. A stock analyst has obtained the following information about MakeMyTrip Limited, an online travel
company in India.

• The company has noncallable bonds with 20 years maturity remaining and a maturity value of
$1,000. The bonds have a 12 percent annual coupon and currently sell at a price of $1,273.8564.
• The current risk-free rate is 6.35 percent, and the expected return on the market is 11.35 percent. The
company beta is 1.3585. The company’s tax rate is 35 percent.
• The company anticipates that its proposed investment projects will be financed with 70 percent debt
and 30 percent equity.

What is the company’s estimated weighted average cost of capital (WACC)? (8.04%)

12. What is the company’s weighted average cost of capital (WACC)? Hatch Corporation’s target capital
structure is 40 percent debt, 50 percent common stock, and 10 percent preferred stock. Information
regarding the company’s cost of capital can be summarized as follows: (9.70%)

• The company’s bonds have a nominal yield to maturity of 7 percent.

• The company’s preferred stock sells for $42 a share and pays an annual dividend of $4 a share.
• The company’s common stock sells for $28 a share, and is expected to pay a dividend of $2 a
share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate
of 7 percent a year.
• The firm will be able to use retained earnings to fund the equity portion of its capital budget.
• The company’s tax rate is 40 percent.

13. ABC Company has asked a group of financial consultants to help them determine their component and
average costs of capital. The consultants have been able to gather the following information: The
current price of the firm’s 10-year, $1000 face value, 10% annual coupon bonds is $1,134. The price
of the firm’s preferred stock is $70 and pays dividends of $8 per year. The common stock has a
current price of $27 per share, expects to pay $2 per share in annual dividends next year, and has an
expected annual growth rate in dividends of 6%. The market value of the sources of financing are debt
at $2,500,000, common stock at $6,000,000, and preferred stock at $500,000. The firm is in a 40% tax
bracket.

• What is the yield to maturity of the firm’s debt? (8%)

• What is the firm’s after-tax cost of debt? (4.8%)
• What is the firm’s cost of equity? (13.4%)
• What is the firm’s weighted average cost of capital? (10.9%)