Chapter 2 – Capital Structure

Chapter 14 – Fundamentals of Corporate Finance (Ross, Westerfield,

Jordan)

1. [Cost of Equity] The Drogon Co. just issued a dividend of $2.40 per share
on its common stock. The company is expected to maintain a constant 5.5
percent growth rate in its dividends indefinitely. If the stock sells for $52 a
share, what is the company’s cost of equity?

2. [Cost of Equity] The Rhaegel Corporation’s common stock has a beta of

1.05. If the risk-free rate is 5.3 percent and the expected return on the market is
12 percent, what is the company’s cost of equity capital?

3. [Cost of Equity] Stock in Daenerys Industries has a beta of 0.85. The

market risk premium is 8 percent, and T-bills are currently yielding 5 percent.
The company’s most recent dividend was $1.60 per share, and dividends are
expected to grow at an annual rate of 6 percent indefinitely. If the stock sells
for $37 per share, what is your best estimate of the company’s cost of equity?

5. [Cost of Preferred Stock] Holdup Bank has an issue of preferred stock with
a stated dividend of $6 that just sold for $96 per share. What is the bank’s cost
of preferred stock?

6. [Cost of Debt] Viserion, Inc., is trying to determine its cost of debt. The
firm has a debt issue outstanding with 15 years to maturity that is quoted at 107
percent of face value. The issue makes semiannual payments and has an
embedded cost of 7 percent annually. What is the company’s pretax cost of
debt? If the tax rate is 35 percent, what is the after-tax cost of debt?
7. [Cost of Debt] Jiminy’s Cricket Farm issued a 30-year, 8 percent (per year)
semiannual bond seven years ago. The bond currently sells for 95 percent of its
face value. The company’s tax rate is 35 percent.
a. What is the pre-tax cost of debt?
b. What is the after-tax cost of debt?
c. Which is more relevant, the pretax or the after-tax cost of debt? Why?

8. [Cost of Debt] For the firm in Problem 7, suppose the book value of the debt
issue is $80 million. In addition, the company has a second debt issue on the
market, a zero coupon bond with seven years left to maturity; the book value of
this issue is $35 million, and the bonds sell for 61 percent of par. What is the
company’s total book value of debt? The total market value? What is your best
estimate of the after-tax cost of debt now?

9. [WACC] Targaryen Corporation has a target capital structure of 60 percent

common stock, 5 percent preferred stock, and 35 percent debt. Its cost of equity
is 14 percent, the cost of preferred stock is 6 percent, and the pretax cost of
debt is 8 percent. The relevant tax rate is 35 percent. What is the company’s
WACC?

10. [WACC] Lannister Manufacturing has a target debt-equity ratio of 0.65. Its
cost of equity is 15 percent, and its cost of debt is 9 percent. If the tax rate is 35
percent, what is the company’s WACC?

11. [Capital Structure] Fama’s Llamas has a weighted average cost of capital
of 8.9 percent. The company’s cost of equity is 12 percent, and its pretax cost
of debt is 7.9 percent. The tax rate is 35 percent. What is the company’s target
debt-equity ratio?
14. [WACC] Starset, Inc., has a target debt-equity ratio of 1.05. Its WACC is
9.4 percent, and the tax rate is 35 percent.
a. If the company’s cost of equity is 14 percent, what is its pretax cost of debt?
b. If instead you know that the after-tax cost of debt is 6.8 percent, what is the
cost of equity?

15. [WACC] Given the following information for Watson Power Co., find the
WACC. Assume the company’s tax rate is 35 percent.
 Debt: 8,000 bonds with a 6.5 percent coupon outstanding, $1,000 par
value, 20 years to maturity, selling for 92 percent of par; the bonds make
semiannual payments.
 Common stock: 250,000 shares outstanding, selling for $57 per share;
the beta is 1.05.
 Preferred stock: 15,000 shares that have an annual dividend of $5,
currently selling for $93 per share.
 Market: 8 percent market risk premium and 4.5 percent risk-free rate.

23. [Cost of Equity] Minder Industries stock has a beta of 1.5.The company
just paid a dividend of $.8, and the dividends are expected to grow at 5 percent.
The expected return on the market is 12 percent, and Treasury bills are yielding
5.5 percent. The most recent stock price for the company is $61.
a. Calculate the cost of equity using the DCF method.
b. Calculate the cost of equity using the SML method.
Chapter 16 – Fundamentals of Corporate Finance (Ross, Westerfield,
Jordan)

1. [EBIT and Leverage] Ghost, Inc., has no debt outstanding and a total
market value of $250,000. Earnings before interest and taxes, EBIT, are
projected to be $28,000 if economic conditions are normal. If there is strong
expansion in the economy, then EBIT will be 30 percent higher. If there is a
recession, then EBIT will be 50 percent lower. The company is considering a
$90,000 debt issue with an interest rate of 7 percent. The proceeds will be used
to repurchase shares of stock. There are currently 5,000 shares outstanding.
Ignore taxes for this problem.
a. Calculate earnings per share (EPS) under each of the three economic
scenarios before any debt is issued. Also calculate the percentage changes in
EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that the company goes through with
recapitalization. What do you observe?

2. [EBIT and Taxes and Leverage] Repeat parts (a) and (b) in Problem 1
assuming the company has a tax rate of 35 percent.

4. [Break-even EBIT] Round Hammer is comparing two different capital

structures: An all-equity plan (Plan I) and a levered plan (Plan II). Under Plan
I, the company would have 160,000 shares of stock outstanding. Under Plan II,
there would be 80,000 shares of stock outstanding and $2.8 million in debt
outstanding. The interest rate on the debt is 8 percent, and there are no taxes.
a. If EBIT is $350,000, which plan will result in the higher EPS?
b. If EBIT is $500,000, which plan will result in the higher EPS?
c. What is the break-even EBIT?