Cost

of Capital
1. 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. 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. The 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 the dividend
yield is $1.20/$30 = 4%.) The marginal tax rate is 40%.
Required:
a. In order to maintain the present capital structure, how much of the new investment must be
financed by common equity?
b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without
issuing additional shares of equity, what is its 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? No numbers are required to answer
this question.
2. Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the
company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by
investors. What is the company's cost of preferred stock for use in calculating the WACC?
3. O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of
common from retained earnings based on the CAPM?
4. Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have
been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF
approach, what is the cost of common from retained earnings?
5. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15%
preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and
the cost of common using retained earnings is 12.75%. The firm will not be issuing any new stock. What is
its WACC?
6. To help finance a major expansion, Castro Chemical Company sold a non-callable bond several years ago
that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a
price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of
debt for use in the WACC calculation?
7. Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend
payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently
 sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of
5% would be incurred. What would be the cost of equity from new common stock?
8. Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is
expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a
share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of
45% debt and 55% common equity. What is the company’s WACC if all the equity used is from retained
earnings?
9. You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10%
preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is
6.00%, the cost of common from retained earnings is 11.25%, and the tax rate is 40%. The firm will not be
issuing any new common stock. What is Quigley's WACC?
10. Keys printing plans to issue a $1,000 par value, 20-year non-callable bond with a 7.00% annual coupon,
paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the
corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC
change if the new tax rate was adopted?
11. S. Bouchard and Company hired you as a consultant to help estimate its cost of common equity. You have
obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% (constant). The CEO thinks, however,
that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF
approach, by how much would the cost of common from retained earnings change if the stock price
changes as the CEO expects?
12. Sapp Trucking’s balance sheet shows a total of non-callable $45 million long-term debt with a coupon rate
of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The
balance sheet also shows that the company has 10 million shares of common stock, and the book value of
the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50
per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the
WACC should be based on market value weights, but the president thinks book weights are more
appropriate. What is the difference between these two WACCs?
13. Bolster Foods’ (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%.
The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The
balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value
per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is
12.25%. The company recently decided that its target capital structure should have 35% debt, with the
balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target
capital structures. What is the sum of these three WACCs?
14. Daves Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the
following information. (1) The firm's non-callable bonds mature in 20 years have an 8.00% annual coupon,
a par value of $1,000, and a market price of $1,050.00. (2) The company’s tax rate is 40%. (3) The risk-free
rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure
consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of
common stock, and it does not expect to issue any new shares. What is its WACC?
15. Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data:
The yield on the company’s outstanding bonds is 7.75%; its tax rate is 40%; the next expected dividend is
$0.65 a share; the dividend is expected to grow at a constant rate of 6.00% a year; the price of the stock is
$15.00 per share; the flotation cost for selling new shares is F = 10%; and the target capital structure is 45%
debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its
capital budget?
16. The CFO of Lenox Industries hired you as a consultant to help estimate its cost of common equity. You
have obtained the following data: (1) rd = yield on the firm’s bonds = 7.00% and the risk premium over its
own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g =
8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used
methods and then to indicate the difference between the highest and lowest of these estimates. What is that
difference?
17. Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics,
including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average
cost of capital. The balance sheet and some other information are provided below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000

Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders' equity 80,000,000
Total liabilities and shareholders' equity $139,000,000

The stock is currently selling for $15.25 per share, and its non-callable $1,000 par value, 20-year, 7.25%
bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month
Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the
stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5
years. The firm's tax rate is 40%.
a. What is the best estimate of the after-tax cost of debt?
b. Based on the CAPM, what is the firm's cost of common stock?
c. Which of the following is the best estimate for the weight of debt for use in calculating the
firm’s WACC?
d. What is the best estimate of the firm's WACC?


Answers:
1. $15,000,000, 8.4%
2. 9.08%
3. 11.30%
4. 12.94%
5. 9.26%
6. 5.08%
7. 13.37%
8. 7.67%
9. 8.15%
10. 0.70%
11. -1.84%

12. P0 $22.50 Book value weights-WRONG!!!
Shares outstanding (millions) 10 Capital Weights Cost rates Product
bond coupon rate (not used) 7.00% Debt $45.00 40.91% 3.60% 1.47%
YTM = rd 6.00% Equity $65.00 59.09% 14.00% 8.27%
rs 14.00% Total $110.00 100.00% WACC = 9.75%
Tax rate 40%
BV debt (millions) $45.00 Market value weights--RIGHT!!!
BV equity (millions) $65.00 Capital Weights Cost rates Product
MV debt (millions) $50.00 Debt $50.00 18.18% 3.60% 0.65%
MV equity (millions) = # sh × P0 = $225.00 Equity $225.00 81.82% 14.00% 11.45%
AT cost of debt = rd(1 − T) 3.60% Total $275.00 100.00% WACC = 12.11%
Difference = 2.36%

13. BOOK VALUE WEIGHTS

Capital Weights Cost rates Product
Debt $25.00 33.33% 4.80% 1.60%
Tax rate 40% Equity $50.00 66.67% 12.25% 8.17%
Target wd 35.00% Total capital $75.00 100.00% WACC = 9.77%
Target wce 65.00%
Coupon rate 8.50% MARKET VALUE WEIGHTS
YTM = rd 8.00% Capital Weights Cost rates Product
rd(1 – T) 4.80% Debt $27.00 11.89% 4.80% 0.57%
rs 12.25% Equity $200.00 88.11% 12.25% 10.79%
Number of shares (millions) 10 Total capital $227.00 100.00% WACC = 11.36%

Price per share $20.00 TARGET WEIGHTS

BV per share $5.00 Capital Weights Cost rates Product
Book equity = BV/sh × No. Shs $50.00 Debt NA 35.00% 4.80% 1.68%
Market equity = P0 × No. Shs $200.00 Equity NA 65.00% 12.25% 7.96%
Book value of debt (millions) $25.00 Total capital NA 100.00% WACC = 9.64%
Market value of debt (millions) $27.00
Sum of the 3 WACCS = 30.77%

14. Coupon rate 8.00%

Maturity 20
Bond price $1,050.00
Par value $1,000
Tax rate 40%
rRF 4.50%
RPM 5.50%
b 1.20
wd 35%
ws 65%
Bond yield 7.51%
rd(1 – T) 4.51%
Cost of equity, rs = rRF + b(RPM) 11.10%
WACC = wd(rd)(1 – T) + ws(rs) = 8.79%
 15. YTM 7.75%
Tax rate 40%
D1 $0.65
g 6.00%
P0 $15.00
F 10.0%
wd 45%
ws 55%
rd(1 – T) 4.65%
re = D1/(P0 × (1 − F)) + g 10.81%
WACC = wd(rd)(1 – T) + ws(rs) = 8.04%

16. Bond yield 7.00% D1 $1.20

Risk premium 4.00% P0 $35.00
rs 11.00% g 8.00%
rs 11.43%
rRF 5.00%
RPM 6.00% Max 12.50%
b 1.25 Min 11.00%
rs 12.50% Difference 1.50%