Question 1

Using the WACC in practice: Poly's Parrot Shops has found that its cost of common equity capital is 17 percent. It has 7-year maturity semiannual bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Poly's if it is subject to a 35 percent marginal tax rate?

Accepted Answer

The answer of Using the WACC in practice: Poly's Parrot...

Question 2

The cost of debt: Dynamo Corporation has semiannual bonds outstanding with 12 years to maturity and are currently priced at $1,080.29. If the bonds have a coupon rate of 8 percent, then what is the equivalent annual return (EAR) to the investor for purchasing the bonds at the described price?

Accepted Answer

First, we need to calculate the annual coupon payment: 
Annual coupon payment = Semiannual coupon rate * Face value 
Annual coupon payment = 0.08/2 * $1,000 = $40

Next, we need to calculate the yield to maturity (YTM) of the bond, which is the equivalent annual return (EAR) to the investor:

$1,080.29 = $40/(1 + YTM/2)^24 + $1,000/(1 + YTM/2)^24

Solving for YTM using a financial calculator or Excel, we get YTM = 7.12%. Therefore, the EAR is also 7.12%, which is closest to choice C (7.00%).

Question 3

The cost of equity: TeleNyckel, Inc., has a beta of 1.4 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 9 percent and the market risk premium is 5 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 30 percent?

Accepted Answer

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. Substituting the given values: Cost of Equity = 9% + 1.4 * 5% = 16%. The tax rate does not affect the cost of equity calculation.

Question 4

The cost of equity: Jacque Ewing Drilling, Inc., has a beta of 1.3 and is trying to calculate its cost of equity capital. If the risk-free rate of return is 8 percent and the expected return on the market is 12 percent, then what is the firm's after-tax cost of equity capital if the firm's marginal tax rate is 40 percent?

Accepted Answer

The answer of The cost of equity: Jacque Ewing Drilling,...

Question 5

The cost of equity: Melba's Toast has a preferred share issue outstanding with a current price of $19.50. The firm is expected to pay a dividend of $2.34 per share a year from today. What is the firm's cost of preferred equity?

Accepted Answer

The cost of preferred equity is calculated as the dividend divided by the current price: $2.34 / $19.50 = 0.12 or 12.00%.

Question 6

Using the WACC in practice: Marley's Pipe Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. If the firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, then what is the after-tax weighted average cost of capital for Marley's if it is subject to a 35 percent marginal tax rate?

Accepted Answer

The answer of Using the WACC in practice: Marley's Pipe...

Question 7

The cost of equity: Oasis, Inc., has common shares with a price of $21.12 per share. The firm is expected to pay a dividend of $1.75 one year from today, and dividends are expected to grow at 10 percent for two years after that and then at 5 percent thereafter. What is the implied cost of common equity capital for Oasis?

Accepted Answer

Using the dividend discount model: 
D1 = $1.75
g1 = 10%
g2 = 10%
g3 = 5%
P0 = $21.12
Using the formula: P0 = D1/(r-g1) + D2/(1+r)^2 + D3/(1+r)^3 + ... + Dn(1+g)^n/(r-gn)
where n = infinity
Plug in the numbers: 
$21.12 = $1.75/(r-0.1) + $1.75(1.1)/(1+r)^2 + $1.75(1.1)^2/(1+r)^3 + ... 
Solving for r using a financial calculator or trial and error, we get r = 14%, therefore the implied cost of common equity capital for Oasis is 14%.

Question 8

The cost of equity: The Dedus Shoes, Inc., has common shares with a price of $28.76 per share. The firm paid a dividend of $1.00 yesterday, and dividends are expected to grow at 10 percent for two years and then at 5 percent thereafter. What is the implied cost of common equity capital for Dedus?

Accepted Answer

The cost of equity can be calculated using the Gordon Growth Model (Dividend Discount Model). The formula is: Cost of Equity = (D1 / P0) + g. Here, D1 is the expected dividend next year, P0 is the current stock price, and g is the growth rate. The expected dividend next year (D1) is $1.00 * 1.10 = $1.10. The growth rate after two years is 5%. Therefore, the cost of equity is ($1.10 / $28.76) + 0.05 = 0.089 or 8.9%, which rounds to 9.00%.

Question 9

The cost of equity: RadicalVenOil, Inc., has a cost of equity capital equal to 22.8 percent. If the risk-free rate of return is 10 percent and the expected return on the market is 18 percent, then what is the firm's beta if the firm's marginal tax rate is 35 percent?

Accepted Answer

The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Rearranging to solve for Beta: Beta = (Cost of Equity - Risk-Free Rate) / (Market Return - Risk-Free Rate). Substituting the given values: Beta = (22.8% - 10%) / (18% - 10%) = 1.60. The tax rate is irrelevant in this calculation.

Question 10

The cost of equity: Tranquility, Inc., has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility?

Accepted Answer

The answer of The cost of equity: Tranquility, Inc., has...

Question 11

The cost of preferred equity: Billy's Goat Coats has a preferred share issue outstanding with a current price of $38.89. The firm last paid a dividend on the issue of $3.50 per share. What is the firm's cost of preferred equity?

Accepted Answer

The cost of preferred equity is calculated as the dividend divided by the current price of the preferred share. Here, it is $3.50 / $38.89 = 0.09 or 9%.

Question 12

The cost of equity: Wally's War Duds has a preferred share issue outstanding with a current price of $26.57. The firm is expected to pay a dividend of $1.86 per share a year from today. What is the firm's cost of preferred equity?

Accepted Answer

Cost of preferred equity is calculated as dividend / preferred share price. So, cost of preferred equity = $1.86 / $26.57 = 0.07 or 7.00%. Therefore, the answer is B.

Question 13

The cost of equity: UltraFlex Diving Boards, Inc., is just paid a dividend of $1.50. If the firm's growth in dividends is expected to remain at a flat 4 percent forever, then what is the cost of equity capital for Ultra Flex Diving Boards if the price of its common shares is currently $26.00?

Accepted Answer

The answer of The cost of equity: UltraFlex Diving Boards,...

Question 14

The cost of equity: Gangland Water Guns, Inc., is expected to pay a dividend of $2.10 one year from today. If the firm's growth in dividends is expected to remain at a flat 3 percent forever, then what is the cost of equity capital for Gangland if the price of its common shares is currently $17.50?

Accepted Answer

The answer of The cost of equity: Gangland Water Guns,...

Question 15

The cost of debt: Beckham Corporation has semiannual bonds outstanding with 13 years to maturity and are currently priced at $746.16. If the bonds have a coupon rate of 8.5 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 35%? Assume that your calculation is made as on Wall Street.

Accepted Answer

To calculate the after-tax cost of debt, we need to first calculate the before-tax cost of debt using the bond price and coupon rate:

Coupon payment = (8.5/2)% x $1000 = $42.50
Number of payments = 13 x 2 = 26
Face value = $1000
Bond price = $746.16

Using a financial calculator, we can find the yield to maturity (YTM) of the bond:
PV = -$746.16 (negative because it represents cash outflow)
PMT = $42.50
FV = $1000
N = 26
Solve for I/Y = YTM/2 = 4.0625%

The before-tax cost of debt is 2 x YTM/2 = 8.125%.

To find the after-tax cost of debt, we need to adjust for the tax savings resulting from the tax-deductibility of interest payments. Since the marginal tax rate is 35%, the after-tax cost of debt is:

After-tax cost of debt = Before-tax cost of debt x (1 - Marginal tax rate)
= 8.125% x (1 - 35%)
= 5.28125%

Rounding to the nearest tenth of a percent, the answer is B) 8.125%.

Question 16

The cost of equity: Rubber Chicken, Inc., was paid a dividend of $1.87 last year. If the firm's growth in dividends is expected to be 10 percent next year and then zero thereafter, then what is the cost of equity capital for Rubber Chicken if the price of its common shares is currently $25.71?

Accepted Answer

The answer of The cost of equity: Rubber Chicken, Inc.,...

Question 17

The cost of debt: PackMan Corporation has semiannual bonds outstanding with nine years to maturity and are currently priced at $754.08. If the bonds have a coupon rate of 7.25 percent, then what is the after-tax cost of debt for Beckham if its marginal tax rate is 30 percent? Complete the calculation as is done on Wall Street.

Accepted Answer

The after-tax cost of debt is the yield to maturity (YTM) of the bond multiplied by (1 - the marginal tax rate). The YTM is the annual interest payment divided by the bond price plus the annual change in the bond price. The annual interest payment is the coupon rate multiplied by the face value of the bond. The annual change in the bond price is the difference between the bond price and the face value of the bond divided by the number of years to maturity.In this case, the coupon rate is 7.25%, the bond price is $754.08, the face value of the bond is $1,000, and the number of years to maturity is nine. The annual interest payment is $72.50. The annual change in the bond price is ($1,000 - $754.08) / 9 = $27.42. The YTM is ($72.50 + $27.42) / $754.08 = 13.25%. The after-tax cost of debt is 13.25% * (1 - 0.30) = 9.275%.

Question 18

Using the WACC in practice: Ronnie's Comics has found that its cost of common equity capital is 15 percent and its cost of debt capital is 12 percent. If the firm is financed with $250,000,000 of common shares (market value) and $750,000,000 of debt, then what is the after-tax weighted average cost of capital for Ronnie's if it is subject to a 35 percent marginal tax rate?

Accepted Answer

The WACC is calculated as: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is equity, V is total value (equity + debt), Re is cost of equity, D is debt, Rd is cost of debt, and Tc is tax rate. Substituting the values: WACC = ($250M/$1000M) * 15% + ($750M/$1000M) * 12% * (1 - 0.35) = 9.6%.

Question 19

Using the WACC in practice: Maloney's, Inc., has found that its cost of common equity capital is 17 percent and its cost of debt capital is 6 percent. If the firm is financed with $3,000,000 of common shares (market value) and $2,000,000 of debt, then what is the after-tax weighted average cost of capital for Maloney's if it is subject to a 40 percent marginal tax rate?

Accepted Answer

Step 1: Calculate the after-tax cost of debt
After-tax cost of debt = Cost of debt x (1 - Tax rate)
= 0.06 x (1 - 0.4)
= 0.036 or 3.6%
Step 2: Calculate the weight of equity and debt
Weight of equity = Market value of equity / Total financing
= 3000000 / (3000000 + 2000000)
= 0.6 or 60%
Weight of debt = 1 - Weight of equity
= 1 - 0.6
= 0.4 or 40%
Step 3: Calculate the after-tax weighted average cost of capital (WACC)
WACC = (Weight of equity x Cost of equity) + (Weight of debt x After-tax cost of debt)
= (0.6 x 0.17) + (0.4 x 0.036)
= 0.102 or 10.2%
Therefore, the answer is C) 11.64%.

Question 20

Using the WACC in practice: Swirlpool, Inc., has found that its cost of common equity capital is 18 percent, and its cost of debt capital is 8 percent. If the firm is financed with 60 percent common shares and 40 percent debt, then what is the after-tax weighted average cost of capital for Swirlpool if it is subject to a 40 percent marginal tax rate?

Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to use the following formula:

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)
where 
E = market value of equity
D = market value of debt
V = E + D
Re = cost of common equity
Rd = cost of debt
T = marginal tax rate

Given that Swirlpool is financed with 60 percent common shares and 40 percent debt, we can calculate the weights as follows:

E/V = 0.6
D/V = 0.4

We also know that:
Re = 18%
Rd = 8%
T = 40%

Using these values, we can plug them into the WACC formula:

WACC = (0.6 x 0.18) + (0.4 x 0.08) x (1 - 0.40)
WACC = 0.108 + 0.024
WACC = 0.132 or 13.2%

However, we need to adjust for the tax rate as the interest on debt is tax-deductible.

So, the after-tax WACC will be:

WACC = 0.132 x (1 - 0.40)
WACC = 0.0792 or 7.92%

Therefore, the answer is C) 12.72%.

Quiz 13: The Cost of Capital