Question 1

The following financial information is available on Rawls Manufacturing Company: 
Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%).

Accepted Answer

Solution: k_e = r_f + β(k_m- r_f) = 0.06 + 1.1(0.12 - 0.06) = 0.126 = 12.6%

Question 2

A firm with a 40 percent marginal tax rate has a capital structure of $60,000,000 in debt and $140,000,000 in equity. What is the firm's weighted cost of capital if the marginal pretax cost of debt is 12 percent, the firm's average pretax cost of debt outstanding is 8%, and the cost of equity is 14.5 percent?

Accepted Answer

Solution: k_a= 0.3(0.12)(1 - 0.4) + 0.7(0.145) = 0.1231 or 12.31%

Question 3

Mid-South Utilities will sell $10 million of $100 par value preferred stock that will pay an annual dividend of $9.75. Mid-South will receive $93.98 per share after flotation costs. If the issue must be retired in 20 years, what is the cost of the preferred issue?

Accepted Answer

Solution:
10.5 % (by calculator)

Question 4

Pluega Inc. issued a $100 million 8.27% coupon debenture bond due in the next 20 years. The bonds each sold for $996. If the bonds pay interest semi-annually, what is Pluega's after cash cost of debt? Assume 40% tax rate.

Accepted Answer

Solution:
8.31(1-.4) = 4.986 or 4.99% (by calculator)

Question 5

Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120 million of long-term debt (kd = 12.5%) and $180 million in retained earnings (k? = 16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%. (Compute answer to nearest .1%).

Accepted Answer

Solution: k_a = 0.40 * 12.5%(1 - 0.4) + 0.60 * 16.0% = 12.6%

Question 6

Easy Slider recently sold a 15 year $1,000 face value bond at a discount for $700 that net the firm $692 after flotation costs. The low coupon bond has a 6% coupon with interest paid semiannually. If Easy Slider has a marginal tax rate of 40 percent, what is its after-tax cost of debt for these bonds?

Accepted Answer

Solution: (Try 5% semiannually ): $692 = $30(15.373) + $1,000(0.231) = $692 Therefore k_d = 10% and k_i = 10%(1 - 0.4) = 6%

Question 7

GQ earned $740,000 before taxes this year. The firm has a debt ratio of 30 percent, a marginal tax rate of 35 percent, and a dividend payout ratio of 40 percent. GQ has no preferred stock. What is GQ's break point for equity?

Accepted Answer

Solution:
Retained earnings = $740,000(1 - 0.35)(1 - 0.4) = $288,600
Break point =$288,600/0.7 = $412,286

Question 8

Wellington Gas has a target capital structure of 50 percent common equity, 40 percent debt, and 10 percent preferred stock. The cost of retained earnings is 16 percent, and the cost of new equity (external) is 16.7 percent. Wellington can sell debentures that will have an after-tax cost of 8.3 percent and the after-tax cost of preferred stock will be 11.9 percent. What is the marginal cost of capital before and after the break point?

Accepted Answer

Solution: k_a1 = 0.5(0.16) + 0.4(0.083) + 0.1(0.119) = 0.1251 k_a2 = 0.5(0.167) + 0.4(0.083) + 0.1(0.119) = 0.1286

Question 9

According to Value Line, Bestway has a beta of 1.15. If 3-month Treasury bills currently yield 7.9 percent and the market risk premium is estimated to be 8.3 percent, what is Bestway's cost of equity capital?

Accepted Answer

Solution: k_e= 7.9% + 1.15(8.3%) = 17.45%

Question 10

PDQ Inc. has a weighted cost of capital of 14.6 percent and has an opportunity to invest in the following average risk projects: 
In which projects should PDQ invest? Assume no capital rationing.

Accepted Answer

Solution: IRR₁ = $10,000/$1,992.43 = 5.019 so IRR = 15% IRR₂ = $21,000/$4,526.84 = 4.639 so IRR = 14% IRR₃ = $18,500/$4,580.34 = 4.039 so IRR = 16% Invest in projects 1 and 3 because their IRR is greater than 14.6%

Question 11

Crickentree has a target capital structure of 30 percent debt and 70 percent equity. If the firm expects to have a net income of $1.7 million and a dividend payout ratio of 40 percent, what will be its equity break point?

Accepted Answer

Solution:
x = $1.7(1 - 0.4)/0.7 = $1.457 or $1,457,143

Question 12

Witin's stock price is currently $34.25 and the current quarterly dividend is $0.25. Consensus estimates for Witin indicate a growth rate in earnings of 10% into the foreseeable future. If Witin plans to sell 1 million shares to raise new capital for expansion, what is the cost of new equity if the issuance costs are 8%?

Accepted Answer

Solution: k_e = (1.00(1.10)/31.51) + .10 = .1349 or 13.49%

Question 13

Northeast Airlines (NA) has a current dividend of $1.80. Dividends are expected to grow at a rate of 7 percent a year into the foreseeable future. What is NA's cost of external equity if its stock can be sold to net $46 a share?

Accepted Answer

Solution: k_e = $1.80(1.07)/$46 + 0.07 = 0.112 or 11.2%

Question 14

Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To finance its capital budget for next year, the firm will sell $50 million of 11 percent debentures at par and finance the balance of its $125 million capital budget with retained earnings. Next year Alpha expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7 percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha's stock is $30. If the firm has a marginal tax rate of 40 percent, what is its weighted cost of capital for the coming year?

Accepted Answer

Solution: k_e= $1.40/$30 + 0.07 = 0.1167 k_a= 0.6(0.1167) + 0.4(0.11)(1 - 0.4) = 0.0964 or 9.64%

Question 15

What is the cost of equity for East Roon, if the firm is expected to always pay a constant dividend of $2.22? The firm's common stock is presently selling for $18.50.

Accepted Answer

Solution: k_e = $2.22/$18.50 = 0.12 or 12%

Question 16

Easy Slider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid annually. After flotation costs, Easy Slider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm's marginal tax rate is 40 percent.

Accepted Answer

Solution: (try 11%) k_i= 11%(0.6) = 6.6% $928 = $100(7.191) + $1000(0.209) ≈ $928 so k_d = 11% k_i= 11%(0.6) = 6.6%

Question 17

Groves, Inc. pays an annual dividend of $1.22. This dividend is expected to continue growing at a rate of about 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The expected market rate of return is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of equity for Groves?

Accepted Answer

Solution: k_e = 0.093 + 1.45(0.135 - 0.093) = 0.154

Question 18

Weltron has a target capital structure of 35% debt and 65% equity. If the firm expects net income of $12.3 million and an annual dividend of $0.12 per share, what is the expected equity break point? There are 12 million shares outstanding.

Accepted Answer

Solution:
Payout = 12,000(.12) = $1,440,000
BP = (12.3 - 1.44)/.65 = $16,707,692

Question 19

What is the cost of a preferred stock with a $100 par value that pays a $9.60 dividend per year? The security has a flotation cost of $3.37 and will be retired at its par value in 20 years.

Accepted Answer

Solution:
Try kp = 10%
$9.60(8.514) + $100(0.149) = $96.63

Question 20

The following financial information is available on Rawls Manufacturing Company: 
Rawls can issue new common stock to net the company $44 per share. Determine the cost of external equity capital using the dividend capitalization model approach. (Compute answer to the nearest 0.1%).

Accepted Answer

Solution: k_e' = (D₁/P_net) + g = [$3.50(1.05)/$44] + 0.05 = 0.1335 or 13.4%

Quiz 12: The Cost of Capital

The following financial information is available on Rawls Manufacturing Company: Rawls can issue new common stock to net the company $44 per share. Determine the cost of internal equity capital using the capital asset pricing model approach. (Compute answer to the nearest 0.1%) .