CHAPTER 9

THE COST OF CAPITAL

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Problems

Easy:

Cost of common stock Answer: d Diff: E

1
. Bouchard Company's stock sells for $20 per share, its last dividend (D 0) was $1.00, and
its growth rate is a constant 6 percent. What is its cost of common stock, rs?

a. 5.0%
b. 5.3%
c. 11.0%
d. 11.3%
e. 11.6%

Cost of common stock Answer: b Diff: E

2
. Your company's stock sells for $50 per share, its last dividend (D 0) was $2.00, and its
growth rate is a constant 5 percent. What is the cost of common stock, rs?

a. 9.0%
b. 9.2%
c. 9.6%
d. 9.8%
e. 10.0%

Cost of common stock Answer: e Diff: E

3
. The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend
paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its
expected growth rate in earnings and dividends is 5 percent. What is Global's cost of
common stock?

a. 12.22%
b. 17.22%
c. 10.33%
d. 9.66%
e. 16.00%

Chapter 9 - Page 1
WACC with Flotation Costs Answer: a Diff: E
4
. An analyst has collected the following information regarding Christopher Co.:

The companys capital structure is 70 percent equity, 30 percent debt.

The yield to maturity on the companys bonds is 9 percent.
The companys 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 companys stock price is $25.
The companys 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 companys WACC.

a. 10.41%
b. 12.56%
c. 10.78%
d. 13.55%
e. 9.29%

Medium:

WACC Answer: d Diff: M

5
. A companys balance sheets show a total of $30 million long-term debt with a coupon
rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a
total current market value of $25 million. The balance sheets also show that that the
company has 10 million shares of stock; the total of common stock and retained earnings
is $30 million. The current stock price is $7.5 per share. The current return required by
stockholders, rS, is 12 percent. The company has a target capital structure of 40 percent
debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital
should you use to evaluate potential projects?

a. 8.55%
b. 9.33%
c. 9.36%
d. 9.87%
e. 10.67%

Chapter 9 - Page 2
Cost of common stock Answer: d Diff: M
6
. The common stock of Anthony Steel has a beta of 1.20. The risk-free rate is 5 percent
and the market risk premium (rM - rRF) is 6 percent. What is the companys cost of
common stock, rs?

a. 7.0%
b. 7.2%
c. 11.0%
d. 12.2%
e. 12.4%

Cost of common stock Answer: b Diff: M

7
. Martin Corporation's common stock is currently selling for $50 per share. The current
dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, then
what is the firm's cost of common stock?

a. 10.0%
b. 10.2%
c. 10.6%
d. 10.8%
e. 11.0%

WACC Answer: b Diff: M

8
. A company has determined that its optimal capital structure consists of 40 percent debt
and 60 percent equity. Given the following information, calculate the firm's weighted
average cost of capital.

rd = 6%
Tax rate = 40%
P0 = $25
Growth = 0%
D0 = $2.00

a. 6.0%
b. 6.2%
c. 7.0%
d. 7.2%
e. 8.0%

Chapter 9 - Page 3
WACC Answer: c Diff: M
9
. Johnson Industries finances its projects with 40 percent debt, 10 percent preferred stock,
and 50 percent common stock.

The company can issue bonds at a yield to maturity of 8.4 percent.

The cost of preferred stock is 9 percent.
The company's common stock currently sells for $30 a share.
The company's dividend is currently $2.00 a share (D 0 = $2.00), and is expected to
grow at a constant rate of 6 percent per year.
Assume that the flotation cost on debt and preferred stock is zero, and no new stock
will be issued.
The companys tax rate is 30 percent.

What is the companys weighted average cost of capital (WACC)?

a. 8.33%
b. 9.32%
c. 9.79%
d. 9.99%
e. 13.15%

WACC Answer: e Diff: M

10
. Dobson Dairies has a capital structure which consists of 60 percent long-term debt and 40
percent common stock. The companys CFO has obtained the following information:

The before-tax yield to maturity on the companys bonds is 8 percent.

The companys common stock is expected to pay a $3.00 dividend at year end (D 1 =
$3.00), and the dividend is expected to grow at a constant rate of 7 percent a year. The
common stock currently sells for $60 a share.
Assume the firm will be able to use retained earnings to fund the equity portion of its
capital budget.
The companys tax rate is 40 percent.

What is the companys weighted average cost of capital (WACC)?

a. 12.00%
b. 8.03%
c. 9.34%
d. 8.00%
e. 7.68%

Multiple part:

Chapter 9 - Page 4
(The following information applies to the next six problems.)

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20
percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid
semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par,
$100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent
would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk
premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells
for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk
premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find r s.
The firm's marginal tax rate is 40 percent.

Cost of debt Answer: e Diff: M

11
. What is Rollins' component cost of debt?

a. 10.0%
b. 9.1%
c. 8.6%
d. 8.0%
e. 7.2%

Cost of preferred stock Answer: d Diff: E

12
. What is Rollins' cost of preferred stock?

a. 10.0%
b. 11.0%
c. 12.0%
d. 12.6%
e. 13.2%

Cost of common stock: CAPM Answer: c Diff: E

13
. What is Rollins' cost of common stock (rs) using the CAPM approach?

a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

Cost of common stock: DCF Answer: c Diff: E

14
. What is the firm's cost of common stock (rs) using the DCF approach?

a. 13.6%
b. 14.1%
c. 16.0%

Chapter 9 - Page 5
 d. 16.6%
e. 16.9%

Cost of common stock: Risk premium Answer: c Diff: E

15
. What is Rollins' cost of common stock using the bond-yield-plus-risk-premium
approach?

a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

WACC Answer: a Diff: E

16
. What is Rollins' WACC?

a. 13.6%
b. 14.1%
c. 16.0%
d. 16.6%
e. 16.9%

(The following information applies to the next three problems.)

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent
preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6
percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently
sells for $90 per share and pays a dividend of $10 per share; however, the firm will net only $80
per share from the sale of new preferred stock. Ross's common stock currently sells for $40 per
share. The firm recently paid a dividend of $2 per share on its common stock, and investors
expect the dividend to grow indefinitely at a constant rate of 10 percent per year.

Cost of common stock Answer: c Diff: E

17
. What is the firm's cost of common stock, rs?

a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%

Cost of preferred stock Answer: b Diff: E

18
. What is the firm's cost of newly issued preferred stock, rps?

Chapter 9 - Page 6
 a. 10.0%
b. 12.5%
c. 15.5%
d. 16.5%
e. 18.0%

WACC Answer: d Diff: E

19
. What is the firm's weighted average cost of capital (WACC)?

a. 9.5%
b. 10.3%
c. 10.8%
d. 11.4%
e. 11.9%

Cost of equity Answer: a Diff: M

20
. Allison Engines Corporation has established a target capital structure of 40 percent debt
and 60 percent common equity. The firm expects to earn $600 in after-tax income
during the coming year, and it will retain 40 percent of those earnings. The current
market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its
expected growth rate is 6 percent. Allison can issue new common stock at a 15 percent
flotation cost. What will Allison's marginal cost of equity capital (not the WACC) be if
it must fund a capital budget requiring $600 in total new capital?

a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
e. 9.7%

Chapter 9 - Page 7
WACC Answer: b Diff: M
21
. Hilliard Corp. wants to calculate its weighted average cost of capital (WACC). The
companys CFO has collected the following information:

The companys long-term bonds currently offer a yield to maturity of 8 percent.

The companys stock price is $32 per share (P0 = $32).
The company recently paid a dividend of $2 per share (D0 = $2.00).
The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%).
The company pays a 10 percent flotation cost whenever it issues new common
stock (F = 10%).
The companys target capital structure is 75 percent equity and 25 percent debt.
The companys tax rate is 40 percent.
The company anticipates issuing new common stock during the upcoming year.

What is the companys WACC?

a. 10.67%
b. 11.22%
c. 11.47%
d. 12.02%
e. 12.56%

Chapter 9 - Page 8
 Financial Calculator Section

Multiple Choice: Problems

Medium:

(The following information applies to the next four problems. Financial calculator required.)

You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastic
goods: plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an
assistant to the Vice-President of Finance. This is a position with high visibility and the
opportunity for rapid advancement, providing you make the right decisions. Your boss has asked
you to estimate the weighted average cost of capital for the company. Following are balance
sheets and some information about CGT.

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 face 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

You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share
and that CGT bonds are selling for $889.50 per bond. These bonds have a 7.25 percent annual
coupon rate, with semi-annual payments. The bonds mature in twenty years. The beta for your
company is approximately equal to 1.1. The yield on a 6-month Treasury bill is 3.5 percent and
the yield on a 20-year Treasury bond is 5.5 percent. The expected return on the stock market is
11.5 percent, but the stock market has had an average annual return of 14.5 percent during the
past five years. CGT is in the 40 percent tax bracket.

Chapter 9 - Page 9
CAPM cost of equity Answer: b Diff: M
22
. Using the CAPM approach, what is the best estimate of the cost of equity for CGT?

a. 10.10%
b. 12.10%
c. 12.30%
d. 15.40%
e. 15.60%

After-tax cost of debt Answer: d Diff: M

23
. What is best estimate for the after-tax cost of debt for CGT?

a. 2.52%
b. 4.20%
c. 4.35%
d. 5.04%
e. 5.37%

Weights for WACC Answer: d Diff: M

24
. Which of the following is the best estimate for the weights to be used when calculating
the WACCC?

a. we = 57.6% and wd = 42.4%

b. we = 65.2% and wd = 34.8%
c. we = 66.7% and wd = 33.3%
d. we = 67.8% and wd = 32.2%
e. we = 72.4% and wd = 27.6%

WACC Answer: e Diff: M

25
. What is the best estimate of the WACC for CGT?

a. 8.65%
b. 8.92%
c. 9.18%
d. 9.75%
e. 9.83%

Component cost of debt Answer: b Diff: M

26
. Hamilton Company's 8 percent coupon rate, quarterly payment, $1,000 par value bond,
which matures in 20 years, currently sells at a price of $686.86. The company's tax rate
is 40 percent. Based on the nominal interest rate, not the EAR, what is the firm's
component cost of debt for purposes of calculating the WACC?

Chapter 9 - Page 10
 a. 3.05%
b. 7.32%
c. 7.36%
d. 12.20%
e. 12.26%

WACC Answer: a Diff: M

27
. A stock analyst has obtained the following information about J-Mart, a large retail chain:
(1) The company has noncallable bonds with 20 years maturity remaining and a maturity
value of $1,000. The bonds have a 12 percent annual coupon and currently sell at a
price of $1,273.8564.
(2) Over the past four years, the returns on the market and on J-Mart were as follows:

Year Market J-Mart

2001 12.0% 14.5%
2002 17.2 22.2
2003 -3.8 -7.5
2004 20.0 24.0

(3) The current risk-free rate is 6.35 percent, and the expected return on the market is
11.35 percent. The company's tax rate is 35 percent.

The company anticipates that its proposed investment projects will be financed with 70
percent debt and 30 percent equity. What is the company's estimated weighted average
cost of capital (WACC)?

a. 8.04%
b. 9.00%
c. 10.25%
d. 12.33%
e. 13.14%

Chapter 9 - Page 11
 CHAPTER 9
ANSWERS AND SOLUTIONS

Chapter 9 - Page 12
1. Cost of common stock Answer: d Diff: E

The cost of common stock is:

rs = $1(1.06)/$20 + 0.06 = 0.053 + 0.06 = 0.113 = 11.3%.

2. Cost of common stock Answer: b Diff: E

$2.00(1.05)
rs = + 5% = 9.2%.
$50

3. Cost of common stock Answer: e Diff: E

$0.90(1.05)
rs = + 0.05 = 0.1600 = 16.00%.
$8.59

4. WACC with Flotation Costs Answer: a Diff: E

WACC = wdrd(1 - T) + wcere. rd is given = 9%. Find re:

re = 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%.

5. WACC Answer: d Diff: M

Weights should be based on the target capital structure: w d = 40% and we =

60%. The cost of debt should be based on the yield of 11.11%.
WACC = 0.60 (12%) + 0.4 (1-.4) (11.11%) = 9.87%.

6. Cost of common stock Answer: d Diff: M

The cost of common equity as calculated from the CAPM is

rs = rRF + (rM - rRF)b
= 5% + (6%)1.2
= 12.2%.
7
. Cost of common stock Answer: b Diff: M

$2.00(1.06)
rs = + 0.06% = 10.24% 10.2%.
$50

8. WACC Answer: b Diff: M

Find the cost of common stock:

rs = D1/P0 + g = $2(1.0)/$25 + 0%; rs = 0.08 = 8%.

Finally, calculate WACC, using rs = 0.08, and rd = 0.06, so

WACC = (D/A)(1 - Tax rate)rd + (E/A)rs
= 0.4(1 - 0.4)(0.06) + 0.6(0.08) = 0.0624 6.2%.
9
. WACC Answer: c Diff: M

The cost of common stock is: rs = D1/P0 + g = $2.12/$30 + 0.06 = 13.07%.

 The cost to the company of the bonds is the YTM multiplied by 1 minus the tax
rate:
rd = YTM(1 - T) = 8.4%(0.7) = 5.88%.

The cost of the preferred is given as 9%.

The weighted average cost of capital is then

WACC = wd(rd) + wps(rps) + wce(rs)
WACC = 0.4(5.88%) + 0.1(9%) + 0.5(13.07%) = 9.79%.

10. WACC Answer: e Diff: M

The firm will not be issuing new equity because there are adequate retained
earnings available to fund available projects. Therefore, WACC should be
calculated using rs.

rs = D1/P0 + g
= $3.00/$60.00 + 0.07
= 0.12 = 12%.

WACC = wdrd(1 - T) + wcers

= (0.6)(0.08)(1 - 0.4) + (0.4)(0.12)
= 0.0768 = 7.68%.
11. Cost of debt Answer: e Diff: M

Time line:
0 rd / 2 ? 1 2 3 4 40 6-month
Periods

PMT = 60 60 60 60 60
VB = 1,000 FV = 1,000

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent)
are equal. Thus, the before-tax cost of debt to Rollins is 12 percent. The
after-tax cost of debt equals:
rd,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000;
Output: I = 6.0% = rd/2.
rd = 6.0% 2 = 12%.
rd(1 - T) = 12.0%(0.6) = 7.2%.

12. Cost of preferred stock Answer: d Diff: E

Cost of preferred stock: rps = $12/$100(0.95) = 12.6%.

13
. Cost of common stock: CAPM Answer: c Diff: E

Cost of common stock (CAPM approach):

rs = 10% + (5%)1.2 = 16.0%.

14. Cost of common stock: DCF Answer: c Diff: E

Cost of common stock (DCF approach):

$2.00(1.08)
rs = + 8% = 16.0%.
$27
15
. Cost of common stock: Risk premium Answer: c Diff: E

Cost of common stock (Bond yield-plus-risk-premium approach):

rs = 12.0% + 4.0% = 16.0%.
16
. WACC Answer: a Diff: E

WACC = wdrd(1 - T) + wpsrps + wcers

= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56% 13.6%.

17

. Cost of common stock Answer: c Diff: E

$2.00(1.10)
rs = + 0.10 = 15.5%.
$40.00

18. Cost of preferred stock Answer: b Diff: E

$10
rps = = 12.5%.
$80
19. WACC Answer: d Diff: E

20
. Cost of equity Answer: a Diff: M

Calculate the retained earnings break point:

Given:
Net income = $600; Debt = 0.4; Equity = 0.6; Dividend payout = 0.6.
Break pointRE = $600(1 - 0.6)/0.6 = $400.
Allison will need new equity capital; capital budget exceeds Break pointRE.

Use the dividend growth model to calculate re:

D0 1 g $2.20 1.06
re = + g = + 0.06
P0 1 F $28 1 0.15
= 0.0979 + 0.06 = 0.1579 15.8%.

21. WACC Answer: b Diff: M

The correct answer is b, 11.22%. As there are no retained earnings, the

equity portion of the capital budget must be funded using new common
equity.

WACC = Wd(rd)(1 - T) + wce(re)

= 0.25(0.08)(1 - 0.4) + 0.75[($2.00 x 1.06)/($32(1 - 0.1))
+ 0.06]
= 0.25(0.0480) + 0.75(0.1336)
= 0.1122 = 11.22%.

22. CAPM Cost of Equity Answer: b Diff: M

rs = 5.5% + 1.1(11.5%-5.5%) = 12.10%.

23. After-tax cost of debt Answer: d Diff: M

N=40 I=? PV=-889.50 PMT=36.25 FV=1,000

 I=4.2

rd = 4.2(2) = 8.4%.

rd after-tax = 8.4%(1-0.40) = 5.04%.

24. Weights for WACC Answer: d Diff: M

Use market values for estimating the weights, since target values are not
available.
Market value of equity = Ve = $7.50(10 million) = $75 million.
Market value of debt = Vd = $889.50(40,000) = $35.58 million.
We = $75/($75+$35.58) = 0.678 = 67.8%.
Wd = $35.58/($75+$35.58) = 0.322 = 32.2%.

25. WACC Answer: e Diff: M

WACC = 0.678 (12.10%) + 0.322 (5.04%) = 9.83%.

26 WACC = wdrd(1 - T) + wpsrps + wcers

= 0.4(6%) + 0.1(12.5%) + 0.5(15.5%)
= 11.4%.

. Component cost of debt Answer: b Diff: M

Time line:
0 rd = ? 1 2 3 4 80
Quarters
PMT = 20 20 20 20 20
VB = 686.86 FV = 1,000

Financial calculator solution:

Calculate the nominal YTM of bond:
Inputs: N = 80; PV = -686.86; PMT = 20; FV = 1,000.
Output: I = 3.05% periodic rate.
Nominal annual rate = 3.05% 4 = 12.20%.
Calculate rd after-tax: rd,AT = 12.20%(1 - T) = 12.20%(1 - 0.4) = 7.32%.
27
. WACC Answer: a Diff: M

WACC = [(0.7)(rd)(1 - T)] + [(0.3)(rs)].

a. Use bond information to solve for rd:
N = 20; PV = -1,273.8564; PMT = 120; FV = 1,000.
Solve for rd = 9%.
b. To solve for rs, we can use the SML equation, but we need to find beta.
Using Market and J-Mart return information and a calculator's regression
feature we find b = 1.3585. So rs = 0.0635 + (0.1135 - 0.0635)(1.3585) =
0.1314 = 13.14%.
c. Plug these values into the WACC equation and solve:
WACC = [(0.7)(0.09)(1 - 0.35)] + [(0.3)(0.1314)] = 0.0804 = 8.04%.