Chapter 20: Cost of Capital

Multiple Choice Questions 1. Which of the following statements is false? A. Financing total assets is called the financial structure decision. B Capital structure is how invested capital is financed. C. The financial structure is $34,000 if the total assets are $34,000. D. The invested capital is $50,000 if the total assets are $50,000. Level of difficulty: Medium Solution: D Invested capital = all interest-bearing liabilities + total equity The invested capital is $50,000 if the invested capital (all interest-bearing liabilities + total equity) is $50,000, not necessarily total assets. 2. If an all-equity firm is expected to earn and pay out a $5.50 dividend forever (in perpetuity), what is the value of the firms stock given a cost of equity is 15 percent? A. $37 B. $36 C. $38 D. $40 Level of difficulty: Medium Solution: A
V = X 5.50 = = $37 K e 0.15

3. What is the earnings yield given a $40,000 earnings figure, a $10 market price per share, and 10,000 shares outstanding? A. 0.5 B. 0.4 C. 0.3 D. 4,000 Level of difficulty: Medium Solution: B
40 ,000 = $4 10 ,000 EPS 4 EarningsYi eld = = = 0.4 P 10 EPS =

4. What does a firm have to earn given the following? MV of debt = $40,000; MV of equity = $69,000; ke = 12.5%; kd = 7% A. $11,425 B. $2,800 C. $8,625 D. $10,099 Level of difficulty: Medium Solution: A
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To satisfy bond holders, 40,000 (7%) = 2,800 To satisfy equity holders, 69,000 (12.5%) = 8,625 Total minimum earnings = 2,800 + 8,625 = $11,425 5. Which of the following statements is true? A. When ROE < ke, management is adding value to the firm. B. When ROE > ke , management is destroying the firms value. C. When ROE > ke, the market price goes above the book value of the investment. D. When ROE = ke, the market price goes above the book value of the investment. Level of difficulty: Medium Solution: C When ROE > ke, the management is adding value to the firm and the market price goes above the book value of the investment. When ROE = ke, the management is neither increasing nor destroying firms value. When ROE < ke, the management is destroying firms value. 6. Which of the following is not an input in the calculation of WACC? A. Book values of equity and debt B. Market values of equity and debt C. Cost of equity D. Corporate tax rate Level of difficulty: Medium Solution: A Market values are used to calculate the weights of equity and debt, not book values. 7. To increase the stock price of a firm that is assumed to grow at a constant rate g, A. increase the cost of equity. B. increase the constant growth rate. C. decrease the dividend payout ratio. D. increase the retention ratio. Level of difficulty: Medium Solution: B D1 EPS ( Payout ) EPS (1 b) = = Recall P = ke g ke g ke g To increase P, increase payout, or decrease retention ratio, or decrease cost of equity, or increase g. 8. Star Inc. just paid a $9.50 dividend, which is expected to grow at a constant rate. Recent EPS is $10.50 and net income is $550,000. Total equity is $1,100,000 and the cost of equity is 12 percent. What is the share market price? A. $142.50 B. $135.70 C. $130.90 D. $129.90 Level of difficulty: Difficult Solution: A
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10 .5 9.5 550 ,000 = 0.1 0.5 = 0.05 10 .5 1,100 ,000 D1 9.5(1.05 ) P= = = 142 .5 ke b ROE 0.12 0.05 g = b ROE =

9. Which of the following firms is a growth firm? A. ROE > ke B. ROE < ke C. ROE = ke D. Net income ke Level of difficulty: Medium Solution: A A growth firm is the one that adds values to the firm and has growth opportunities: ROE > ke. 10. Which of the following statements is false? A. Star firms have both higher PVGO and PVEO. B. Google and Yahoo are examples of turnarounds. C. Cash cows could be called growth stocks as well. D. Utility firms are examples of cash cows. Level of difficulty: Medium Solution: C Cash cows do not have significant growth opportunities. Practice Problems Use the information below to answer Problems 11 to 13. BALANCE SHEET Cash $140,000 Accounts payable $200,000 Marketable securities 200,000 Wage payable 100,000 Accounts receivable 40,000 Short-term debt 250,000 Inventory 1,000,000 Long-term debt 690,000 Total liabilities $1,240,000 Fixed assets 900,000 Common stock 950,000 Retained earnings 90,000 Total assets $2,280,000 Total Equity & Liabilities $2,280,000 INCOME STATEMENT Sales $1,200,000 CGS 400,000 Amortization 90,000 Interest 56,400 EBT $653,600 Taxes $261,440 NI $392,160 Shares outstanding 300,000
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11. What is the cost of equity (ke) given RF = 5%, beta ()= 1.2, expected market return (ERM) = 10%? Level of difficulty: Easy Solution:
k e = RF + ( ER M RF ) = 5 +1.2(10 5) = 11 %

12. What is the market price and market-to-book ratio assuming the firms stock is a perpetuity and retention ratio (b) = 0? Level of difficulty: Medium Solution:
P= D1 EPS 1 (1 b) EPS 1 (1 0) NI /# 392 ,160 = = = = = 11 .88 ke ke ke ke 300 ,000 0.11

( g = b ROE = 0%) P ROE NI / E 392 ,160 = = = = 3.43 BVPS ke ke (950 ,000 + 90 ,000 )( 0.11)

13. Calculate invested capital and ROI. Level of difficulty: Medium Solution: Invested Capital = short-term debt + long-term debt + total equity = 250,000 + 690,000 + 950,000 + 90,000 = 1,980,000 ROI=NI/Invested capital = 392,160/1,980,000 = 19.8% 14. Provide two reasons why the cost of a security to a company differs from its required return in capital markets. Level of difficulty: Medium Solution: i) Flotation costs: Issuing expenses on new securities have to be paid from the gross proceeds of an issue so that the firms initial cash inflow doesnt match the funds provided by investors. ii) Taxes: The tax deductibility of interest payments made by the firm separates the cost of debt from the corresponding market yield. 15. A firm is going to finance a new project 100 percent with debt, through a new bond issue. Since the firm is only using debt to finance the project, the NPV of the project should be calculated using the cost of debt as the discount rate. Is this statement true, false, or uncertain? Explain. Level of difficulty: Medium Solution: The statement is false. The cost of capital for a new project depends on the use of funds, not the source. Even if this particular project will be funded with debt, it is probably only one of many projects that the firm undertakes. The firm, over time, will raise financing through a number of sources, including internal funds, new equity, new preferred shares, and new debt.
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The source of funding for this project is from the pool of available funds. Therefore the cost of capital for the project should be the WACC, appropriately adjusted for the risk of this particular project. 16. Calculate the WACC (Weighted Average Cost of Capital). The market values of equity and debt are $500,000 and $600,000, respectively. The before-tax cost of debt = 6%; RF = 4%; beta () = 1.5; the market risk premium = 10%; and the tax rate = 40%. Level of difficulty: Medium Solution:
k e = RF + ( ER M RF ) = 4 +1.5(10 ) = 19 % WACC = 19 % 500 ,000 600 ,000 + 6%(1 0.4) = 10 .6% 500 ,000 + 600 ,000 500 ,000 + 600 ,000

17. What is VFed given the expected earnings per share on the S&P500 is $10 and the long-term U.S. bond rate is 5 percent? Level of difficulty: Medium Solution:
V fed = Exp ( EPS ) 10 = = $250 kTbond 1% 5% 1%

18. AB Inc. just announced its EPS of $3. Retention ratio (b) = 0.7. The earnings are expected to grow at 10 percent for one year and then grow at 4 percent indefinitely. Given that k e = 15%. What is the market price? Level of difficulty: Medium Solution: D1 = D0 (1 + g1) = EPS0 (1 b)(1 + g1) = (3)(1 0.7)(1.1) = 0.99 D2 = D1 (1 + g2) = 0.99 (1.04) = 1.03 D2 1.03 P = = = 9.36 1 ke g 2 0.15 0.04 0.99 + 9.36 P0 = = $9 1.15 19. Calculate the cost of issuing new equity for a firm assuming: issue costs are 5 percent of share price after taxes; market price per share = $20; current dividend = $3.50; and the constant growth rate in dividends is 5 percent. Level of difficulty: Medium Solution:
D1 +g P (1 F ) 3.5(1.05 ) = + 0.05 20 (1 0.05 ) = 24 % ke =

20. A small brokerage firm and a software development company are both separately considering developing and marketing a new software package. Neither party is aware that the other is
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considering this project and it is NOT at any point going to become a joint venture. These new software packages will organize mutual fund data into a new type of database and then run a series of complicated algorithms on that new database. The beta of the brokerage firm is 0.8 and the beta of the software firm is 1.4. The risk-free rate is 5 percent and the market risk premium is 10 percent. The NPV of the project, using a 13 percent discount rate, is +$1 million. However, using a 19 percent discount rate, the project has a $500,000 NPV. Should either or both parties go ahead with the project? Level of difficulty: Medium Solution: The appropriate discount rate should be based on the risk of the project, not on the risk of the individual companies undertaking the project. In this case, the development of a software package would be more closely associated with the risk of the software development firm. Therefore the appropriate discount rate would be 5 + 1.4 10 = 19%. At this discount rate, the NPV of the project is negative and neither party should proceed with the project. 21. Suppose a firm uses a constant WACC to calculate the NPV of all of its capital budgeting projects, rather than adjusting for risk of the individual projects. What errors will the firm make in its capital budgeting decisions? Level of difficulty: Medium Solution: The firm will make both type 1 and type 2 errors. In the first case, it will tend to accept highrisk projects that it should have rejected. Since the project has high risk, using the WACC (which is too low a discount rate given the risk of the project) will overestimate the NPV and will lead management to accept projects it should well have rejected. In the second case, the firm may reject low-risk projects that it should have accepted. Again, using the WACC (in this case a discount rate that is too high given the risk) will underestimate the NPV and lead management to reject projects it should have accepted. 22. A firm has common shares outstanding with a market capitalization rate of 12 percent. The current market price is $13.80, and dividend payments for this year are expected to be $0.28. What is the per share implied growth rate? Level of difficulty: Medium Solution: P0=D1/(r-g)=D0*(1+g)/(r-g) 13.8=0.28*(1+g)/(0.12-g) g=0.098 23. A firms earnings and dividends are expected to grow at a constant rate indefinitely, and it is expected to pay a dividend of $9.20 next year. Expected EPS and BVPS next year are $10.50 and $30, respectively. The cost of equity is 12 percent and there are 10,000 shares outstanding. Calculate the firms value assuming that the retention ratio stays the same and the market value of debt is $500,000. Level of difficulty: Difficult Solution:

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NI EPS 10 .5 = = = 35 % E BVPS 30 10 .5 9.2 g = b ROE = 0.35 = 0.04 10 .5 D1 9 .2 P= = = $115 ke g 0.12 0.04 ROE = V =115 10 ,000 + 500 ,000 = $1,650 ,000

24. Calculate the cost of equity using constant growth DDM given the following: current dividend = $2.50; payout ratio = 0.7 (assuming it is not changing); ROE = 15%; and the current market price of the stock = $11.50. Is the current management adding

to or reducing the shareholders value? Level of difficulty: Difficult Solution:

g = b ROE = (1 payout ) ROE = (1 0.7)15% = 4.5% D 2.5(1.045 ) ke = 1 + g = + 0.045 = 27% P 11.5 ROE = 15% < k e = 27%

Therefore, management is reducing the shareholders value. 25. Calculate PVGO and PVEO given the following information: ROE1 = 20%; ROE2 = 25%; further investment (Inv) = $50; BVPS = $10; and ke = 15%. Is this firm a star? If not, what is it according to Boston Consulting Group? Level of difficulty: Difficult Solution:
P= = ROE 2 k e ROE 1 BVPS Inv + ( ) ke (1 + k e ) ke

0.20 10 50 0.25 0.15 + 0.15 1.15 0.15 = 13 + 29 = $42

PVGO = $29, PVEO = $13 ROE1 and ROE2 are both greater than cost of equity, therefore this firm has both high PVGO and PVEO. It is a star. 26. A firm has the following capital structure based on market values: equity 65 percent and debt 35 percent. The current yield on government T-bills is 10 percent, the expected return on the market portfolio is 15 percent, and the firms beta is approximated at 0.85. The firms common shares are trading at $25, and the current dividend level of $3 per share is expected to grow at an annual rate of 3.5 percent. The firm can issue debt at a 2 percent premium over the current risk-free rate. The firms tax rate is 40 percent, and the firm is considering a project to be funded out of internally generated funds that will not alter the firms overall risk. This project requires an initial investment of $11.5 million and promises to generate net annual after tax cash flows of $1.4 million perpetually. Should this project be undertaken? Level of difficulty: Difficult
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Solution: We must first determine the firms cost of equity. We have enough information to estimate ke using either the CAPM or the constant dividend growth model. CAPM ke = RF + B(ERM RF) = 0.1 + 0.85 (0.15 0.10) = 14.25% Dividend Growth ke = D1 P0 + g = 3(1.035)/25 + 0.035 = 15.92% We can now estimate the cost of debt from the information given. I = $1,000[rf + 2%] = 120 kb = (1 T) I NPb = (1 0.4) 120 1,000 = 7.2% From the ranges of costs we have derived, we can now solve for the firms weighted average cost of capital. k = B Ki V + E Ke V k = 0.35 0.072 + 0.65 0.1425 = 11.8% OR k = 0.35 0.072 + 0.65 0.1592= 12.9% We can now perform a net present value calculation. NPV = 11.5 + 1.4 0.118 = $.364 million NPV = 11.5 + 1.4 0.129 = $0.647 million The net present value calculations indicate that the project should be undertaken at a discount rate of 11.8 percent but should not be undertaken at a discount rate of 12.9 percent. 27. A firm has the following balance sheet items: Common stock: 300,000 shares at $8 each Retained earnings Debt: 15% coupon, 15 years to maturity Preferred shares: 12% dividend $2,400,000 900,000 1,800,000 1,200,000

The before-tax interest cost on new 15-year debt would be 10 percent, and each $1,000 bond would net the firm $975 after issuing costs. Common shares could be sold to net the firm $8 per share, a 12 percent discount from the current market price. Current shareholders expect a 15 percent return on their investment. Preferred shares could be sold at par to provide a yield of 9 percent, with after-tax issuing and underwriting expenses amounting to 5 percent of par value. The firms tax rate is 45 percent, and internally generated funds are insufficient to finance anticipated new capital projects. Compute the firms marginal cost of capital. Level of difficulty: Difficult Solution: We first compute the costs of each source of funds: Debt: NP = $975; Assuming annual coupons I = (.10)($1,000) = $100; n = 15 So we have:
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1 1 (1 + K )15 i 975 =100 (1 .45 ) Ki

1 +1,000 (1 + K i )15

Solving for Ki, as shown in Chapter 6, we get: By financial calculator: PMT = 100(1 - .45) = $55; PV = -975; FV = 1,000; N = 15. Then compute I/Y will give 5.75%, which is the firms annual after-tax cost of debt. Preferred: kp = Dp NPp = 0.09 0.95 = 9.47% Equity: kne = kne Pe NPe = (0.15) *(8 1.12) / ( 8) = 16.80% We next compute the market value of each component: Debt: The market value of debt outstanding is: B
1 1 (1 +.1 )15 0 =150 0.1 0 1 + ,0 0 1 0 =$1,3 0 .3 8 0 (1 +.1 )15 0

1,800 = $2,484,547

Preferred: The market value is the total dividend payments divided by the market capitalization rate. P = 0.12 ($1,200,000) 0.09 = $1,600,000 Equity: Shares are currently trading at (8 1.12) = $8.96 E = 300,000 ($8.96) = $2,688,000 Note the value of retained earnings is incorporated into the current market price of equity. Total market value =V=B+P+E = $2,484,547 + $1,600,000 + $2,688,000 = $6,772,547 Finally we can compute the weighted average cost of capital: k = B V kb + P V kp + E V ke k = [2,484,547 6,772,547 0.0575] + [1,600,000 6,772,547 0.0947] + [2,688,000 6,772,547 0.1680] =11.01% 28. A company can issue new 20-year bonds at par that pay 10 percent annual coupons. The net proceeds to the firm (after-taxes) will be 95 percent of par value. They estimate that new preferred shares providing a $2 annual dividend could be issued to investors at $25 per share to net the firm $22 per share issued (after taxes). The company has a beta of 1.20, and present market conditions are such that the risk-free rate is 6 percent, while the expected return on the market index is 12 percent. The firms common shares presently trade for $30, and they estimate the net proceeds from a new common share issue would be $26 per share (after tax considerations). The firms tax rate is 40 percent. A. Determine the firms cost of long-term debt, preferred shares, and common equity financing (internal and external sources) under the conditions above. B. What is the firms weighted average cost of capital assuming that they have a target capital structure consisting of 30 percent debt, 10 percent preferred equity, and 60%
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common equity. Assume that they have $2 million in internal funds available for reinvestment and require $3 million in total financing. C. Suppose everything remains as above, except that the company decides it needs $5 million in total financing. Calculate the firms marginal cost of capital. Level of difficulty: Difficult Solution: A. Cost of Debt: NP = $950; Assuming annual coupons I = (.10)($1,000) = $100; n = 20 So we have:
1 1 (1 + K ) 20 i 950 =100 (1 .40 ) Ki 1 +1,000 (1 + K i ) 20

Solving for Ki, as shown in Chapter 6, we get: By financial calculator: PMT = 100(1 - .40) = $60; PV = -950; FV = 1,000; N = 20. Then compute I/Y will give 6.45%, which is the firms annual after-tax cost of debt. Cost of Preferred shares: K= 2/22 = 9.09% Cost of Common Shares: K= 6+1.20(12-6) = 13.2% 13.2% *(30/26)= 15.23% B. Common equity Break Point = 2/0.6 = $3.33 m; Therefore since they only need $3m in total financing, all of the common equity financing can be raised from internal funds. So, we should use the cost of common equity using internal funds. WACC= 0.3(6.45) + 0.1(9.09) + 0.6(13.2) = 10.76% C. Since $5 m > the break point of $3.33 m, the appropriate common equity cost is the cost of new equity, or 15.23%. MCC = 0.3(6.45) + 0.1(9.09) + 0.6(15.23) = 11.98% 29. A. Company ABC plans to issue 20-year bonds with a 12.80 percent coupon rate, with coupons paid semi-annually and a par value of $1,000. After-tax flotation costs (issuing & underwriting costs) amount to 2.5 percent of par value. The firms tax rate is 50 percent. Determine the firms effective annual after-tax cost of debt. B. Company ABC plans to issue $50 par preferred shares (P/S) with annual dividends of $6 (i.e., a 12 percent dividend yield). They estimate flotation costs to be $2 per share after taxes. Find the firms cost of P/S. C. Company ABC wishes to make a new issue of common shares (C/S). The current market price ( P ) is $25, D1 = $1.75 (expected dividend at the end of this year), while g = 9 0
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percent per year indefinitely. Flotation costs and discounts amount to $1 per share after taxes. Find the firms cost of issuing new common shares: i) Using the dividend valuation approach. ii) Using CAPM, given that the risk-free rate is 11%, the expected return on the market is 18 percent, and the beta for ABC is 0.95. D. Find the cost of internally generated common equity: i) Using dividend model approach ii) Using CAPM approach. E. Find the WACC if the firm wishes to raise funds in the following proportions: 30 percent debt, 20 percent P/S, and 50 percent CE (common equity) and it believes all of the CE component can be raised using internally generated funds. Assume the cost of internally generated funds is 17.5 percent. F. Now suppose the firm wants to raise $10 million for investment purposes and it only has $2 million of internally generated funds available. Determine the break point of the CE component. G. Determine the marginal cost of capital (MCC) if the firm must raise funds beyond the break point. Assume the cost of new common equity issues is 18 percent. Level of difficulty: Difficult Solution: A. Cost of LT debt: NP = $975; Semi-annual coupons I = (.1280/2)($1,000) = $64; n = 20*2 = 40 So we have:
1 1 (1 + K ) 40 i 975 = 64 (1 .50 ) Ki 1 +1,000 (1 + K i ) 40

Solving for Ki, as shown in Chapter 6, we get: By financial calculator: PMT = 64(1 - .50) = $32; PV = -975; FV = 1,000; N = 40. Then compute I/Y will give 3.31%, which is the firms semi-annual after-tax cost of debt. So, their annual after-tax cost of debt = (1.0331)2 1 = 6.73% B. Cost of Preferred Shares:
kp = Dp NPp = 6 = 12.50%. 48

C. and D. Cost of Common Equity Financing: (i) Dividend Growth Model Approach: D D 1. 75 1. 75 k e = 1 g = . 09=16%, and k ne = 1 g= . 09=16. 29 . P0 25 NP 24 (ii) CAPM Approach:

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k e = RF[ ER M RF ] i =11 1811 0. 95=17. 65 %, and P 25 k ne = 0 k e = 17. 65 =18. 38 . NP 24

[ ] [ ]
=

E. Using ke, we get:

WACC = B P CE ki + k p + ke V V V = (.30)(6.54%) + (.20)(12.50%) + (.50)(17.5%) = 13.21%

Break

F. Po int

Internal Funds Available $2 m = = $4 m. CE .50 V

G. Since $10m > break point of $4m, kCE = kCS , and we obtain,
MCC = B P CE ki + k p + k ne = (.30 )(6.54 %) + (.20)(12 .50%) + (.50 )(18 %) = 13 .46 % V V V

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