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COST OF CAPITAL Exercise Problems

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37 views2 pages

COST OF CAPITAL Exercise Problems

Uploaded by

pilramos831
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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COST OF CAPITAL

Your company’s stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a
constant 5 percent, and the company will incur a flotation cost of 15 percent if it sells new
common stock. What is the firm’s cost of new equity, ke?

ke = + 5% = 9.94%.

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?
The firm must issue new equity to fund its capital projects, so we need to find the cost of new
equity capital, ke:

ke = D1/(P0 - F) + g

= $2.50/($50 - $3) + 4%

= $2.50/$47 + 4%

= 5.32% + 4%

= 9.32%.

Cost of Equity

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 P 0 = $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?
Use the dividend growth model to calculate ks:

ks = +g= + 0.06

= 0.0833 + 0.06 = 0.1433  14.3%.

An analyst has collected the following information regarding Christopher Co.:

 The company’s capital structure is 70 percent equity and 30 percent debt.


 The yield to maturity on the company’s bonds is 9 percent.
 The company’s year-end dividend is forecasted to be $0.80 a share.
 The company expects that its dividend will grow at a constant rate of 9 percent a year.
 The company’s stock price is $25.
 The company’s tax rate is 40 percent.
 The company anticipates that it will need to raise new common stock this year. Its investment
bankers anticipate that the total flotation cost will equal 10 percent of the amount issued.
Assume the company accounts for flotation costs by adjusting the cost of capital. Given this
information, calculate the company’s WACC.

WACC = wdkd(1 - T) + wcke. kd is given = 9%. Find ke:


ke = D1/[P0(1 - F)] + g
= $0.8/[$25(1 - 0.1)] + 0.09
= 0.125556.

Now you can calculate WACC:


WACC = (0.3)(0.09)(0.6) + (0.7)(0.125556) = 10.41%.
WACC (D1/P0) +g  (0.80/22.5) + 9%  0.1255556

(70%*0.125556) + (30%*9%*60%)  0.0878889 + 0.0162  0.1040889 or 10.41%


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?
WACC = [0.3  0.084  (1 - 0.4)] + [0.7  ($2.5/($45  (1 - 0.1)) + 0.07)]
= 10.73%.

Billick Brothers is estimating its WACC. The company has collected the following information:
12.5 cost of equity (40%*9%*60%) + (60%*12.5%) 

 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 that are 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.

What is the company’s WACC?

WACC = wdkd(1 - T) + wcks.

ks = kRF + RPM(b)

ks = 5.5% + 5%(1.4)

ks = 5.5% + 7% = 12.5%.

WACC = wdkd(1 - T) + wcks

WACC = 0.4(9%)(1 - 0.4) + (0.6)12.5%


WACC = 9.66%.

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