End-of-Chapter Questions

Q1. The Pierce Co. just issued a dividend of $2.35 per share on its common stock. The company is
expected to maintain a constant 5 percent growth rate in its dividends indefinitely. If the stock sells for
$44 a share, what is the company’s cost of equity?

Company’s cost of equity is the required return by equity investors which can be calculated using the
DGM equation where:

P0 = D1/(RE-g) => RE= (D1/P0) + g where D1=D0 (1+5%)=$2.35 (1+5%) =$2.4675

 RE= ($2.4675/$44) + 0.05 = 0.1061 or 10.61%

Q2. Hoolahan Corporation’s common stock has a beta of 0.87. If the risk-free rate is 3.6 percent and
the expected return on the market is 11 percent, what is the company’s cost of equity capital?

Β=0.87
Rf=3.6%
E(RM) = 11%

RE= 3.6% + 0.87 x (11% - 3.6%) = 10.04%

Q6. Jiminy’s Cricket Farm issued a 30-year, 6.3 percent semiannual bond 8 years ago. The bond
currently sells for 110 percent of its face value. The company’s tax rate is 22 percent.

a. What is the pretax cost of debt? (RD,BT =?)

C/2 = (6.3% x F)/2
F = $1,000
Bond value (price) = 110% x $1,000 = $1,100
2t =? where t is the number of years remaining until maturity
 2t = 2 (30 – 8) = 44 payments
 Solve for YTM and find: RD,BT = 5.51%

b. What is the aftertax cost of debt? (RD,AT=?)

RD,AT= RD,BT x (1-Tc) = 5.51% (1-0.22) = 4.30%

c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

The aftertax rate is more relevant because that is the actual cost to the company.

Q9. Caddie Manufacturing has a target debt–equity ratio of 0.45. Its cost of equity is 10.3 percent, and
its pretax cost of debt is 6.4 percent. If the tax rate is 21 percent, what is the company’s WACC?

Debt to equity = 0.45 means: D/E = 0.45 (=> D = 0.45E). We have to use this information in order to
calculate the weight of each type of financing.

Usually: WE = E/V

And WD = D/V = D/ (D+E) = 0.45E/(0.45E + E) = 0.45E/1.45E = 0.45/1.45 = 0.3103 or 31.03%

 WE = 100% - WD = 100% - 31.03% = 68.97%

WACC = WE x RE + WD x RD, AT where RD, AT= RD, BT x (1- Tc)

WACC = (68.97% x 10.3%) + [31.03% x (6.4% x (1 – 21%))]

 WACC = 8.67%

Q13. Clifford, Inc., has a target debt–equity ratio of 0.65. Its WACC is 8.1 percent, and the tax rate is
23 percent. (D/E = 0.65 => D = 0.65E. Use it for the calculation of the weights)

Weight of debt: WD = D/V = D/(D+E) = 0.65E/(0.65E+E) = 0.65E/1.65E = 0.65/1.65

Weight of equity: WE= 1 – weight of debt = 1/1.65

a. If the company’s cost of equity is 11 percent (RE), what is its pretax cost of debt (RD, BT=?)?

WACC = WE x RE + WD x [RD, BT x (1- Tc)]

8.1% = (1/1.65 x 11%) + [0.65/1.65 x RD, BT x (1- 23%)]

=> Solve for RD, BT = 4.73%

b. If the aftertax cost of debt is 3.8 percent, what is the cost of equity?

WACC = WE x RE + WD x [RD, BT x (1- Tc)]

Where WACC = 8.1% ; WE = 1/1.65 ; WD =0.65/1.65 and [RD, BT x (1- Tc)] =3.8%

 Solve for RE and find RE = 10.90%

Q14. Given the following information for Lightning Power Co., find the WACC. Assume the company’s
tax rate is 21 percent.

Debt: 16,500 6.2 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity, selling for
108 percent of par; the bonds make semiannual payments.

Common stock: 535,000 shares outstanding, selling for $81 per share; beta is 1.20.

Market: 7 percent market risk premium and 3.1 percent risk-free rate.

We should find the cost of capital (WACC: I have to calculate the total cost of capital considering the
weight of equity and the weight of debt).

WACC = Weighted cost of equity + Weighted cost of debt

WACC = WE x RE + WD x RD, AT where RD, AT= RD, BT x (1- Tc)

1. Calculate first the weights:

Weight of equity is the % of the firm financed by equity: WE= E/V where E is the market value of equity
and V is the total market value of the firm.

Weight of debt is the % of the firm financed by debt: WD= D/V where D is the market value of debt and
V=E+D

 E = number of shares outstanding x Price per share = 535,000 x $81 = $43,335,000

 D = number of bonds outstanding x Price of the bond = 16,500 x (108% x Par value) = 16,500
x (1.08 x 1,000)= $17,820,000
 V = Total market value of the firm = D + E = $17,820,000 + $43,335,000 = $61,155,000
 Now it is possible to calculate the weights:
 WE= E/V = $43,335,000/$61,155,000 = 0.7086 or 70.86% approx.
 WD= D/V = $17,820,000//$61,155,000 = 0.2914 or 29.14% approx

2. Calculate the cost of each type of financing

a. Cost of equity
Using the SML approach:

RE= 3.1% + (1.20 x 7%)= 11.50% THIS IS THE COST OF EQUITY

b. Cost of debt
Using bond pricing equation

Where YTM/2 is the semi-annual cost of debt

Bond value (Bond price) = 108% x Par value = 1.08 x $1,000 = $1,080

C/2 is the semiannual coupon = (Coupon rate x Par value)/2 = 6.2% x $1,000/2 = $31

2t is the number of payments until maturity = 2 x 25 = 50

 YTM = 5.60% THIS IS THE BEFORE-TAX COST OF DEBT (RD,BT)

RD,BT =5.60%

3. Calculate the WACC

WACC = WE x RE + WD x RD, AT where RD, AT= RD, BT x (1- Tc)

WACC = (70.86% x 11.50%) + [29.14% x (5.60% x (1-21%))]

WACC = 9.44%
Q16. An all-equity firm (there is no debt in its capital structure, meaning that the WACC is only the cost
of equity) is considering the following projects:

Project Beta IRR

W 0.80 9.3%
X 0.90 11.4
Y 1.10 12.1
Z 1.35 15.1

The T-bill rate (risk-free rate) is 4 percent, and the expected return on the market is 12 percent (ERM)

a. Which projects have a higher expected return than the firm’s 12 percent cost of capital?

The firm’s 12% cost of capital represents the WACC of the firm.

Compare the IRR of each project to the WACC to answer the question. Projects Y and Z have higher
retrun than the firm’s 12% cost of capital!

Projects Y and Z have IRR > firm’s cost of capital => Based on this rule, projects Y and Z would be
accepted and projects W and X would be rejected.

b. Which projects should be accepted?

(To answer this question, I have to check which projects are accepted/rejected if we adjust for their
risk).

Based on the previous, if we use the firm’s cost of capital (means we do not adjust for risk)

=> ACCEPT Y AND Z AND REJECT W AND X

Adjusting for the risk of each project means, we have to calculate an expected return for each project
given its level of risk! And then compare to the IRR and make the decision accordingly.

The expected return for each project is calculated using the SML equation:

RE = Rf + beta x (E(RM) – Rf)

 For project W: Rw = Rf+ betaW x (E(RM) – Rf) = 4% + (0.80 x (12%-4%)) =0.1040 or 10.40%
 For project X: Rx = Rf+ betax x (E(RM) – Rf) = 4% + (0.90 x (12%-4%)) = 0.1120 or 11.20%
 For project Y: Ry = 0.1280 or 12.80%
 For project Z: Rz = 0.1480 or 14.80%

Now I can compare the IRR of each project to its expected return and make a decision! Select only
projects with an IRR> expected return

For project W: IRR = 9.3% < Rw = 10.40% => Reject W

For project X: IRR = 11.4% > Rx = 11.20 => ACCEPT X

For project Y: IRR = 12.1% < Ry =12.80 => REJECT Y

For project Z: IRR = 15.1% > Rz = 14.80=> ACCEPT Z

c. Which projects will be incorrectly accepted or rejected if the firm’s overall cost of capital were used
as a hurdle rate?

Project X would be incorrectly rejected; Project Y would be incorrectly accepted

Q21. Hankins, Inc., is considering a project that will result in initial aftertax cash savings of $4.3 million
at the end of the first year, and these savings will grow at a rate of 1.9 percent per year indefinitely
(this is a growing perpetuity)

(Those are the incremental CFs of the project)

The firm has a target debt–equity ratio of 0.40 (D/E = 0.40), a cost of equity of 10.8 percent, and an
aftertax cost of debt of 3.2 percent.

The cost-saving proposal (the project we are evaluating) is somewhat riskier than the usual project the
firm undertakes; management uses the subjective approach and applies an adjustment factor of +2
percent to the cost of capital for such risky projects (WACC of the project = WACC of the firm +2%)
Under what circumstances should the company take on the project?

In general, a project has to be accepted only if its NPV > 0

 only if the PV of the future expected CFs > Initial cost!

Step 1 : Find the WACC of the firm where WACC = We x Re + Wd x Rd, at = (1/1.40 x 10.80%) +
(0.40/1.40 x 3.2%) = 8.63%

Step 2: Find the WACC of the project and use as the discount rate.

The project’s discount rate = WACC of the firm +2% = 8.63% +2% = 10.63%

Step 3: Calculate the NPV of the project and make a decision!

PV of future CFs = PV of the growing perpetuity

PV = $4,300,000/(.1063 – .019)
PV = $49,263,502.45
The project can be accepted only if the initial cost is less than $49,263,502.45

Q23. Gabriel Industries stock has a beta of 1.12. The company just paid a dividend of $1.15, and the
dividends are expected to grow at 4 percent. The expected return on the market is 11.4 percent, and
Treasury bills are yielding 3.8 percent. The most recent stock price is $85.

a. Calculate the cost of equity using the dividend growth model method.

b. Calculate the cost of equity using the SML method.

c. Why do you think your estimates in (a) and (b) are so different?

a. Using the dividend discount model, the cost of equity is:

RE = [($1.15)(1.04)/$85] + .04
RE = .0541, or 5.41%

b. Using the CAPM, the cost of equity is:

RE = .038 + 1.12(.114 – .038)

RE = .1231, or 12.31%
c. When using the dividend growth model or the CAPM, you must remember that both are
estimates for the cost of equity. Additionally, and perhaps more importantly, each method of
estimating the cost of equity depends upon different assumptions.