Chapter 10: Cost of Capital:

ST (1)

Longstreet Communications Inc. (LCI) has the following capital structure, which it
considers to be optimal: debt = 25%, preferred stock = 15%, and common stock = 60%.
LCI’s tax rate is 40% and investors expect earnings and dividends to grow at a constant rate
of 6% in the future. LCI paid a dividend of $3.70 per share last year (D0), and its stock
currently sells at a price of $60 per share. Treasury bonds yield 6%, the market risk
premium is 5%, and LCI’s beta is 1.3. These terms would apply to new security offerings:

Preferred: New preferred could be sold to the public at a price of $100 per share, with a
dividend of $9. Flotation costs of $5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 9%.

a. Find the component costs of debt, preferred stock, and common stock.
Assume LCI does not have to issue any additional shares of common stock.
b. What is the WACC?

Answer :

a. Component costs are as follows

Debt at rd = 9%  rd (1-T) = 9% (1-0.4) = 5.4%

Preferred with F = 5%  rps = Preferred dividend = 9$ = 9.5%

Pps (1 – F) 100 (0.95)

Common with DCF  rs = D1 + g = 3.922 $ + 6% = 12.5 %

P0 60 $
Common with CAPM: rs = rRF + RPm (b) = 6% + 5%(1.3) = 12.5%.

b. WACC = wd rd (1 – T ) X wps rps + wce rs

= 0.25 (9%) (1-0.4) + 0.15 (9.5%) + 0.60 (12.5%) = 10.275%.
Problems:
10 - The earnings, dividends, and stock price of Shelby Inc. are expected to grow at
7% per year in the future. Shelby’s common stock sells for $23 per share, its last
dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the
current year.

a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the
market is 13%, what will be the firm’s cost of equity using the CAPM approach?
c. If the firm’s bonds earn a return of 12%, what will rs be using the bond-yieldplus-
risk-premium approach? (Hint: Use the midpoint of the risk premium range.)
d. On the basis of the results of parts a through c, what would you estimate Shelby’s
cost of equity to be?

Answer :
a. 16.3%.
b. 15.4%.
c. 16%.

11- Radon Homes’ current EPS is $6.50. It was $4.42 5 years ago. The company pays
out 40% of its earnings as dividends, and the stock sells for $36.
a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.)
b. Calculate the next expected dividend per share, D1 [D0 _ 0.4($6.50) _ $2.60].
Assume that the past growth rate will continue.
c. What is the cost of equity, rs, for Radon Homes?

Answer :
a. 8%.
b. $2.81.
c. 15.81%.

12- Spencer Supplies’ stock is currently selling for $60 a share. The firm is expected to earn $5.40 per
share this year and to pay a year-end dividend of $3.60.
a. If investors require a 9% return, what rate of growth must be expected for Spencer?
b. If Spencer reinvests earnings in projects with average returns equal to the
stock’s expected rate of return, what will be next year’s EPS? [Hint: g _ROE(Retention ratio).]

Answer :
a. g = 3%.
b. EPS1 = $5.562.
13- Messman Manufacturing will issue common stock to the public for $30. The expected dividend
and growth in dividends are $3.00 per share and 5%, respectively.
If the flotation cost is 10% of the issue proceeds, what is the cost of external equity, r e?

Answer : 16.1%.
14- Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon rate of
9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the issue proceeds, what is the
after-tax cost of debt?

Answer :
(1 _ T) rd = 5.57%.

15- On January 1, the total market value of the Tysseland Company was $60 million. During the year, the
company plans to raise and invest $30 million in new projects.
The firm’s present market value capital structure, shown below, is considered to be optimal. Assume that
there is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at
$30 a share. Stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of
4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so $1.20/$30 _ 4%.)
The marginal corporate tax rate is 40%.
a. To maintain the present capital structure, how much of the new investment must be financed by common
equity?
b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure
without issuing additional shares of equity. What is the WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock.
Qualitatively speaking, what will happen to the WACC?

Answer :
a. $15,000,000.
b. 8.4%

16- Suppose the Schoof Company has this book value balance sheet:
Current assets $30,000,000 Current liabilities $10,000,000
Fixed assets 50,000,000 Long-term debt 30,000,000
Common equity
Common stock
(1 million shares) 1,000,000
Retained earnings 39,000,000
Total assets $80,000,000 Total claims $80,000,000

The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10%,
the same as the rate on new bank loans. The long-term debt consists of 30,000 bonds, each of which has a
par value of $1,000, carries an annual coupon interest rate of 6%, and matures in 20 years. The going rate
of interest on new long-term debt, rd, is 10%, and this is the present yield to maturity on the bonds. The
common stock sells at a price of $60 per share. Calculate the firm’s market value capital structure.

Answer :
Short-term debt = 11.14%;
Long-term debt = 22.03%;
Common equity = 66.83%.
 Chapter 11: Capital Budgeting:

ST (1)

You are a financial analyst for the Hittle Company. The director of capital budgeting has asked you to
analyze two proposed capital investments, Projects X and Y.
Each project has a cost of $10,000, and the cost of capital for each project is 12%.
The projects’ expected net cash flows are as follows:
Expected Net Cash Flows
Year Project X Project Y
0 ($10,000) ($10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
a. Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), and
modified internal rate of return (MIRR).
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these
two projects? Would this conflict exist if r were 5%? (Hint: Plot the NPV profiles.)
e. Why does the conflict exist?

Answer :
Page 983-985 (couldn’t copy)

Problems:

7- Your division is considering two investment projects, each of which requires an up-front expenditure of
$15 million. You estimate that the investments will produce the following net cash flows:
Year Project A Project B
1 $ 5,000,000 $20,000,000
2 10,000,000 10,000,000
3 20,000,000 6,000,000
What are the two projects’ net present values, assuming the cost of capital is 10%? 5%? 15%?

Answer :

5%: NPVA = $16,108,952;

NPVB = $18,300,939.
10%: NPVA = $12,836,213;
NPVB = $15,954,170.
15%: NPVA = $10,059,587;
NPVB = $13,897,838.
8- Edelman Engineering is considering including two pieces of equipment, a truck and an overhead pulley
system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is $17,100,
and that for the pulley system is $22,430. The firm’s cost of capital is 14%. After-tax cash flows, including
depreciation, are as follows:
Year Truck Pulley
1 $5,100 $7,500
2 5,100 7,500
3 5,100 7,500
4 5,100 7,500
5 5,100 7,500
Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct accept/reject decision
for each.

Answer :
NPVT = $409; IRRT = 15%;
MIRRT = 14.54% ; Accept.
NPVP = $3,318; IRRP = 20%;
MIRRP = 17.19%; Accept

9- Davis Industries must choose between a gas-powered and an electric-powered forklift truck for moving
materials in its factory. Since both forklifts perform the same function, the firm will choose only one. (They
are mutually exclusive investments.) The electric-powered truck will cost more, but it will be less
expensive to operate; it will cost $22,000, whereas the gas-powered truck will cost $17,500. The cost of
capital that applies to both investments is 12%. The life for
both types of truck is estimated to be 6 years, during which time the net cash flows for the electric-powered
truck will be $6,290 per year and those for the gaspowered truck will be $5,000 per year. Annual net cash
flows include depreciation expenses. Calculate the NPV and IRR for each type of truck, and decide which
to recommend.

Answer :
NPVE = $3,861; IRRE = 18%;
NPVG = $3,057; IRRG = 18%;
Purchase electric-powered
forklift; it has a higher NPV.

10- Project S has a cost of $10,000 and is expected to produce benefits (cash flows) of $3,000 per year for 5
years. Project L costs $25,000 and is expected to produce cash flows of $7,400 per year for 5 years.
Calculate the two projects’ NPVs, IRRs, MIRRs, and PIs, assuming a cost of capital of 12%. Which project
would be selected, assuming they are mutually exclusive, using each ranking method? Which should
actually be selected?

Answer :

NPVS = $814.33; NPVL = $1,675.34; IRRS = 15.24%;

IRRL = 14.67%; MIRRS = 13.77%; MIRRL = 13.46%; PIS = 1.081;
PIL = 1.067.
11- Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows
are shown below:
Year X Y
0 ($1,000) ($1,000)
1 100 1,000
2 300 100
3 400 50
4 700 50
The projects are equally risky, and their cost of capital is 12%. You must make a recommendation, and you
must base it on the modified IRR (MIRR). What is the MIRR of the better project?

Answer :
MIRRX = 13.59%; MIRRY =13.10%.

12- After discovering a new gold vein in the Colorado mountains, CTC Mining Corporation must decide
whether to mine the deposit. The most cost-effective method of mining gold is sulfuric acid extraction, a
process that results in environmental damage. To go ahead with the extraction, CTC must spend $900,000
for new mining equipment and pay $165,000 for its installation. The gold mined will net the firm an
estimated $350,000 each year over the 5-year life of the vein. CTC’s cost of capital is 14%. For the
purposes of this problem, assume that the cash inflows occur at the end of the year.
a. What are the NPV and IRR of this project?
b. Should this project be undertaken, ignoring environmental concerns?
c. How should environmental effects be considered when evaluating this, or any
other, project? How might these effects change your decision in part b?

Answer :

a. NPV = $136,578;
b. IRR =19.22%.

13- Cummings Products Company is considering two mutually exclusive investments.

The projects’ expected net cash flows are as follows:
Expected Net Cash Flows
Year Project A Project B
0 ($300) ($405)
1 (387) 134
2 (193) 134
3 (100) 134
4 600 134
5 600 134
6 850 134
7 (180) 0
a. Construct NPV profiles for Projects A and B.
b. What is each project’s IRR?
c. If you were told that each project’s cost of capital was 10%, which project should be selected? If the cost
of capital was 17%, what would be the proper choice?
d. What is each project’s MIRR at a cost of capital of 10%? At 17%? (Hint: Consider Period 7 as the end of
Project B’s life.)
e. What is the crossover rate, and what is its significance?
Answer :

b. IRRA = 18.1%; IRRB = 24.0%.

c. 10%: NPVA = $283.34; NPVB = $178.60.
17%: NPVA = $31.05; NPVB = $75.95.
d. (1) MIRRA = 14.07%; MIRRB = 15.89%.
(2) MIRRA =17.57%; MIRRB = 19.91%.

20- The Aubey Coffee Company is evaluating the within-plant distribution system for its new roasting,
grinding, and packing plant. The two alternatives are (1) a conveyor system with a high initial cost, but low
annual operating costs, and (2) several forklift trucks, which cost less, but have considerably higher
operating costs.
The decision to construct the plant has already been made, and the choice here will have no effect on the
overall revenues of the project. The cost of capital for the plant is 8%, and the projects’ expected net costs
are listed in the table:
Expected Net Cost
Year Conveyor Forklift
0 ($500,000) ($200,000)
1 (120,000) (160,000)
2 (120,000) (160,000)
3 (120,000) (160,000)
4 (120,000) (160,000)
5 (20,000) (160,000)
a. What is the IRR of each alternative?
b. What is the present value of costs of each alternative? Which method should
be chosen?

Answer :

a. Undefined.
b. NPVC = $911,067;
NPVF = $838,834

21- Your division is considering two investment projects, each of which requires an upfront expenditure of
$25 million. You estimate that the cost of capital is 10% and that the investments will produce the
following after-tax cash flows (in millions of dollars):
Year Project A Project B
1 5 20
2 10 10
3 15 8
4 20 6
a. What is the regular payback period for each of the projects?
b. What is the discounted payback period for each of the projects?
c. If the two projects are independent and the cost of capital is 10%, which project or projects should the
firm undertake?
d. If the two projects are mutually exclusive and the cost of capital is 5%, which project should the firm
undertake?
e. If the two projects are mutually exclusive and the cost of capital is 15%, which project should the firm
undertake?
f. What is the crossover rate?
g. If the cost of capital is 10%, what is the modified IRR (MIRR) of each project?
Answer :

a. A = 2.67 years; B = 1.5 years.

b. A =3.07 years; B = 1.825 years.
c. NPVA = $12,739,908; choose both.
d. NPVA = $18,243,813; choose A.
e. NPVB = $8,643,390; choose B.
f. 13.53%.
g. MIRRA = 21.93%; MIRRB = 20.96%.

Chapter 15:
ST 1
Watkins Inc. has never paid a dividend, and when it might begin paying dividends is unknown. Its current
free cash flow is $100,000, and this FCF is expected to grow at a constant 7% rate. The weighted average
cost of capital is WACC _ 11%. Watkins currently holds $325,000 of nonoperating marketable securities.
Its long-term debt is $1,000,000, but it has never issued preferred stock. Watkins has 50,000 shares of stock
outstanding.
a. Calculate Watkins’ value of operations.
b. Calculate the company’s total value.
c. Calculate the value of its common equity.
d. Calculate the per share stock price.

Problems:
6- Brooks Enterprises has never paid a dividend. Free cash flow is projected to be $80,000 and $100,000
for the next 2 years, respectively, and after the second year it is expected to grow at a constant rate of 8%.
The company’s weighted average cost of capital is WACC _ 12%.
a. What is the terminal, or horizon, value of operations? (Hint: Find the value of all free cash flows beyond
Year 2 discounted back to Year 2.)
b. Calculate the value of Brooks’ operations.

Answer :
a. HV2 = $2,700,000.
b. $2,303,571.43

7- Dozier Corporation is a fast-growing supplier of office products. Analysts project the following free cash
flows (FCFs) during the next 3 years, after which FCF is expected to grow at a constant 7% rate. Dozier’s
cost of capital is WACC _ 13%.
Year 1 2 3
Free cash flow ($ millions) -$20 $30 $40
a. What is Dozier’s terminal, or horizon, value? (Hint: Find the value of all free
cash flows beyond Year 3 discounted back to Year 3.)
b. What is the current value of operations for Dozier?
c. Suppose Dozier has $10 million in marketable securities, $100 million in debt,
and 10 million shares of stock. What is the price per share?
Answer :
a. $713.33.
b. $527.89.
c. $43.79.

8- The balance sheet of Hutter Amalgamated is shown below. If the 12/31/2007 value of operations is $756
million, what is the 12/31/2007 value of equity?
Balance Sheet, December 31, 2007 (Millions of Dollars)
Assets Liabilities and Equity
Cash $ 20.0 Accounts payable $ 19.0
Marketable securities 77.0 Notes payable 151.0
Accounts receivable 100.0 Accruals 51.0
Inventories 200.0 Total current liabilities $221.0
Total current assets $397.0 Long-term bonds 190.0
Net plant and equipment 279.0 Preferred stock 76.0
Common stock (par plus PIC) 100.0
Retained earnings 89.0
Common equity $189.0
Total assets $676.0 Total liabilities and equity $676.0

Answer : $416 million.

9- The balance sheet of Roop Industries is shown below. The 12/31/2007 value of operations is $651
million and there are 10 million shares of common equity. What is the price per share?

Balance Sheet, December 31, 2007 (Millions of Dollars)

Assets Liabilities and Equity
Cash $ 20.0 Accounts payable $ 19.0
Marketable securities 47.0 Notes payable 65.0
Accounts receivable 100.0 Accruals 51.0
Inventories 200.0 Total current liabilities $135.0
Total current assets $367.0 Long-term bonds 131.0
Net plant and equipment 279.0 Preferred stock 33.0
Common stock (par plus PIC) 160.0
Retained earnings 187.0
Common equity $347.0
Total assets $646.0 Total liabilities and equity $646.0

Answer :$46.90.

10- The financial statements of Lioi Steel Fabricators are shown below, with the actual results for 2007 and
the projections for 2008. Free cash flow is expected to grow at a 6% rate after 2008. The weighted average
cost of capital is 11%.
a. If operating capital as of 12/31/2007 is $502.2 million, what is the free cash flow for 12/31/2008?
b. What is the horizon value as of 12/31/2008?
c. What is the value of operations as of 12/31/2007?
d. What is the total value of the company as of 12/31/2007?
e. What is the price per share for 12/31/2007
Answer
a. $34.96 million.
b. $741.152 million.
c. $699.20 million.
d. $749.10 million.
e. $50.34.

Chapter 16:
ST 1:

The Rogers Company is currently in this situation: (1) EBIT _ $4.7 million; (2) tax rate, T _ 40%; (3) value
of debt, D _ $2 million; (4) rd _ 10%; (5) rs _ 15%; (6) shares of stock outstanding, n0 _ 600,000; and stock
price, P0 _ $30. The firm’s market is stable, and it expects no growth, so all earnings are paid out as
dividends. The debt consists of perpetual bonds.
a. What is the total market value of the firm’s stock, S, and the firm’s total market value, V?
b. What is the firm’s weighted average cost of capital?
c. Suppose the firm can increase its debt so that its capital structure has 50% debt, based on market values
(it will issue debt and buy back stock). At this level of debt, its cost of equity rises to 18.5% and its interest
rate on all debt will rise to 12% (it will have to call and refund the old debt). What is the WACC under this
capital structure? What is the total value? How much debt
will it issue, and what is the stock price after the repurchase? How many shares will remain outstanding
after the repurchase?

ST 2:
Lighter Industrial Corporation (LIC) is considering a large-scale recapitalization. Currently, LIC is financed
with 25% debt and 75% equity. LIC is considering increasing its level of debt until it is financed with 60%
debt and 40% equity. The beta on its common stock at the current level of debt is 1.5, the risk-free rate is
6%, the market risk premium is 4%, and LIC faces a 40% federalplus- state tax rate.
a. What is LIC’s current cost of equity?
b. What is LIC’s unlevered beta?
c. What will be the new beta and new cost of equity if LIC recapitalizes?
Problems:
9- The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Assets (book _ market) $3,000,000
EBIT $500,000
Cost of equity, rs 10%
Stock price, P0 $15
Shares outstanding, n0 200,000
Tax rate, T (federal-plus-state) 40%
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to a
capital structure with 30% debt based on market values, its cost of equity, rs, will increase to 11% to reflect
the increased risk.
Bonds can be sold at a cost, rd, of 7%. Rivoli is a no-growth firm. Hence, all its earnings are paid out as
dividends, and earnings are expectationally constant over time.
a. What effect would this use of leverage have on the value of the firm?
b. What would be the price of Rivoli’s stock?
c. What happens to the firm’s earnings per share after the recapitalization?
d. The $500,000 EBIT given previously is actually the expected value from the
following probability distribution:
Probability EBIT
0.10 ($ 100,000)
0.20 200,000
0.40 500,000
0.20 800,000
0.10 1,100,000
Determine the times-interest-earned ratio for each probability. What is the probability of not covering the
interest payment at the 30% debt level?

Answer :
a. V = $3,348,214.
b. $16.74.
c. $1.84.
d. 10%.
10- Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling
for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company’s EBIT is
$13.24 million, and its tax rate is 15%.
Pettit can change its capital structure by either increasing its debt to 70% (based on market values) or
decreasing it to 30%. If it decides to increase its use of leverage, it must call its old bonds and issue new
ones with a 12% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them
with new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to
complete the capital structure change.
The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of
equity, rs, is 14%. If it increases leverage, rs will be 16%. If it decreases leverage, rs will be 13%. What is
the firm’s WACC and total corporate value under each capital structure?

Answer :
30% debt: WACC =11.14%;
V =$101.023 million.
50% debt: WACC = 11.25%;
V =$100 million.
70% debt: WACC =11.94%;
V = $94.255 million
11- Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA
currently has $20 million in debt carrying a rate of 8%, and its stock price is $40 per share with 2 million
shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. EBIT is
$14.933 million, and BEA faces a 40% federal-plus-state tax rate. The market risk premium is 4%, and the
risk-free rate is 6%. BEA is considering increasing its debt level to
a capital structure with 40% debt, based on market values, and repurchasing shares with the extra money
that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt
will be 9%. BEA has a beta of 1.0.
a. What is BEA’s unlevered beta? Use market value D/S when unlevering.
b. What are BEA’s new beta and cost of equity if it has 40% debt?
c. What are BEA’s WACC and total value of the firm with 40% debt?

Answer
a. 0.870.
b. b = 1.218; rs =10.872%.
c. WACC =8.683%; V = $103.188 million
12- Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and
common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan
to do so in the future. To estimate how much its debt would cost at different debt levels, the company’s
treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the
following table:
Market Debt- Market Equity- Market Debt to-
Value to- Value to- Equity Bond Before-Tax
Ratio (wd) Ratio (wce) Ratio (D/S) Rating Cost of Debt (rd)
0.0 1.0 0.00 A 7.0%
0.2 0.8 0.25 BBB 8.0
0.4 0.6 0.67 BB 10.0
0.6 0.4 1.50 C 12.0
0.8 0.2 4.00 D 15.0
Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free
rate is 5%, the market risk premium is 6%, and its tax rate is 40%. Elliott estimates that if it had no debt, its
“unlevered” beta, bU, would be 1.2. Based on this information, what is the firm’s optimal capital structure,
and what would the weighted average cost of capital be at the optimal capital structure?

Answer : 11.45%.