Question 1

Design Interiors has a cost of equity of 18.6 percent and a pretax cost of debt of 9.7 percent.The firm's target weighted average cost of capital is 12 percent and its tax rate is 35 percent.What is the firm's target debt-equity ratio?

Accepted Answer

WACC = 0.12 = (1 - x)(0.186) + (x)(0.097)(1 - 0.35)x = 0.5370Debt-equity ratio = 0.5370/(1 - 0.5370) = 1.16

Question 2

The Five and Dime Store has a cost of equity of 15.8 percent,a pretax cost of debt of 7.7 percent,and a tax rate of 35 percent.What is the firm's weighted average cost of capital if the debt-equity ratio is 0.40?

Accepted Answer

WACC = (1/1.40)(0.158) + (0.40/1.40)(0.077)(1 - 0.35) = 12.72 percent

Question 3

The preferred stock of Dolphin Pools pays an annual dividend of $6.25 a share and sells for $42 a share.The tax rate is 35 percent.What is the firm's cost of preferred stock?

Accepted Answer

R_p = $6.25/$42 = 14.88 percent

Question 4

The 7.5 percent preferred stock of Home Town Brewers is selling for $45 a share.What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Accepted Answer

R_p = (0.075 × $100)/$45 = 16.67 percent

Question 5

Orchard Farms has a pretax cost of debt of 7.68 percent and a cost of equity of 15.2 percent.The firm uses the subjective approach to determine project discount rates.Currently,the firm is considering a project to which it has assigned an adjustment factor of -0.5 percent.The firm's tax rate is 34 percent and its debt-equity ratio is 0.45.The project has an initial cost of $4.3 million and produces cash inflows of $1.27 million a year for 5 years.What is the net present value of the project?

Accepted Answer

Project cost of capital = [(1/1.45)(0.152) + (0.45/1.45)(0.0768)(1 - 0.34)] - 0.005 = 0.115558NPV = -$4.3m + $1.27m(PVIFA_{5, 11.5558%}) = $328,895

Question 6

Alpha Industries is considering a project with an initial cost of $7.4 million.The project will produce cash inflows of $1.54 million a year for seven years.The firm uses the subjective approach to assign discount rates to projects.For this project,the subjective adjustment is +1.5 percent.The firm has a pretax cost of debt of 8.6 percent and a cost of equity of 13.7 percent.The debt-equity ratio is 0.0.65 and the tax rate is 35 percent.What is the net present value of the project?

Accepted Answer

WACC = (1/1.65)(0.137) + (0.65/1.65)(0.086)(1 - 0.35) = 0.105051Project WACC = 0.105051 + 0.015 = 0.120051NPV = -$7.4m + ($1.54m)(PVIFA_{7, 12.0051%}) = -$372,951

Question 7

Smith and Weston has 55,000 shares of common stock outstanding at a price of $31 a share.It also has 3,000 shares of preferred stock outstanding at a price of $62 a share.The firm has 8 percent,12-year bonds outstanding with a total face value of $400,000.The bonds are currently quoted at 101.2 percent of face and pay interest semiannually.What is the capital structure weight of the firm's preferred stock if the tax rate is 35 percent?

Accepted Answer

Weight of debt = $186,000/$2,295,800 = 8.10 percent

Question 8

Kim's Bridal Shoppe has 15,000 shares of common stock outstanding at a price of $11 a share.It also has 2,000 shares of preferred stock outstanding at a price of $34 a share.There are 50 bonds outstanding that have a 7.5 percent semiannual coupon.The bonds mature in six years,have a face value of $1,000,and sell at 96 percent of par.What is the capital structure weight of the common stock?

Accepted Answer

Weight of common stock = $165k/$281k = 58.72 percent

Question 9

Santa Claus Enterprises has 174,000 shares of common stock outstanding at a current price of $46 a share.The firm also has two bond issues outstanding.The first bond issue has a total face value of $250,000,pays 7.7 percent interest annually,and currently sells for 102.5 percent of face value.The second bond issue consists of 5,000 bonds that are selling for $993 each.These bonds pay 6.5 percent interest annually and mature in eight years.The tax rate is 34 percent.What is the capital structure weight of the firm's debt?

Accepted Answer

Weight of debt = $5,221,250/$13,225,250 = 39.48 percent

Question 10

Bermuda Cruises issues only common stock and coupon bonds.The firm has a debt-equity ratio of 0.65.The cost of equity is 18.3 percent and the pretax cost of debt is 9.9 percent.What is the capital structure weight of the firm's equity if the firm's tax rate is 34 percent?

Accepted Answer

Weight of equity = 1/(1.65) = 60.61 percent

Question 11

Country Kitchen's cost of equity is 15.3 percent and its aftertax cost of debt is 6.9 percent.What is the firm's weighted average cost of capital if its debt-equity ratio is 0.58 and the tax rate is 30 percent?

Accepted Answer

WACC = (1/1.58)(0.153) + [(0.58/1.58)(0.069)] = 12.21 percent

Question 12

Piedmont Hotels is an all-equity firm with 60,000 shares of stock outstanding.The stock has a beta of 1.27 and a standard deviation of 13.8 percent.The market risk premium is 9.1 percent and the risk-free rate of return is 4.5 percent.The company is considering a project that it considers riskier than its current operations so it wants to apply an adjustment of 1 percent to the project's discount rate.What should the firm set as the required rate of return for the project?

Accepted Answer

Project cost of capital = 0.045 + 1.27(0.091) + 0.01 = 17.06 percent

Question 13

A firm wants to create a WACC of 10.4 percent.The firm's cost of equity is 14.5 percent and its pretax cost of debt is 8.5 percent.The tax rate is 34 percent.What does the debt-equity ratio need to be for the firm to achieve its target WACC?

Accepted Answer

WACC = 0.104 = (1 - x)(0.145) + (x)(0.085)(1 - 0.34)]x = 0.4612Debt-equity ratio = 0.4612/(1 - 0.4612) = 0.86

Question 14

Western Electric has 23,000 shares of common stock outstanding at a price per share of $57 and a rate of return of 14.2 percent.The firm has 6,000 shares of 7 percent preferred stock outstanding at a price of $48 a share.The preferred stock has a par value of $100.The outstanding debt has a total face value of $350,000 and currently sells for 102 percent of face.The yield to maturity on the debt is 8.49 percent.What is the firm's weighted average cost of capital if the tax rate is 34 percent?

Accepted Answer

WACC = ($1,311,000/$1,956,000)(0.142) + ($288,000/$1,956,000)(0.07 × $100/$48) + ($357,000/$1,956,000)(0.0849)(1 - 0.34) = 12.69 percent

Question 15

The Color Box uses a combination of common stock,preferred stock,and debt financing.The company wants preferred stock to represent 8 percent of the total financing.It also wants to structure the firm in a manner that will produce a weighted average cost of capital of 10.25 percent.The aftertax cost of debt is 5.1 percent,the cost of preferred is 9.3 percent,and the cost of common stock is 15.6 percent.What percentage of the firm's capital funding should be debt financing?

Accepted Answer

(1 - 0.08 - x)(0.156) + (0.08)(0.093) + (x)(0.051) = 0.1025x = 46.12 percent = Weight of debt

Question 16

Gulf Coast Tours currently has a weighted average cost of capital of 11.3 percent based on a combination of debt and equity financing.The firm has no preferred stock.The current debt-equity ratio is 0.58 and the aftertax cost of debt is 6.4 percent.The company just hired a new president who is considering eliminating all debt financing.All else constant,what will the firm's cost of capital be if the firm switches to an all-equity firm?

Accepted Answer

WACC = 0.113 = (1/1.58)(x) + (0.58/1.58)(0.061)x = 14.32 percent

Question 17

Cromwell's Interiors is considering a project that is equally as risky as the firm's current operations.The firm has a cost of equity of 13.7 percent and a pretax cost of debt of 8.4 percent.The debt-equity ratio is .65 and the tax rate is 40 percent.What is the cost of capital for this project?

Accepted Answer

Project cost of capital = (1/1.65)(0.137) + (0.65/1.65)(0.084)(1 - 0.40) = 10.29 percent

Question 18

Great Lakes Packing has two bond issues outstanding.The first issue has a coupon rate of 9 percent,matures in 3 years,has a total face value of $6 million,and is quoted at 108 percent of face value.The second issue has a 7.5 percent coupon,matures in 16 years,has a total face value of $18 million,and is quoted at 97 percent of face value.Both bonds pay interest semiannually.What is the firm's weighted average aftertax cost of debt if the tax rate is 35 percent?

Accepted Answer

Market values: ($6m × 1.08) + ($18m × 0.97) = $6.48m + $17.46m = $23.94mAftertax cost of debt = [($6.48m/$23.94m)(0.060443) + ($17.46m/$23.94m)(0.078321] × (1 - 0.35) = 4.78 percent

Question 19

The 7.5 percent preferred stock of Rock Bottom Floors is selling for $60 a share.What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

Accepted Answer

R_p = (0.075 × $100)/$60 = 12.50 percent

Question 20

Aaron's Rentals has 58,000 shares of common stock outstanding at a market price of $36 a share.The common stock just paid a $1.64 annual dividend and has a dividend growth rate of 2.8 percent.There are 12,000 shares of 6 percent preferred stock outstanding at a market price of $51 a share.The preferred stock has a par value of $100.The outstanding bonds mature in 17 years,have a total face value of $750,000,a face value per bond of $1,000,and a market price of $1,011 each.The bonds pay 8 percent interest,semiannually.The tax rate is 34 percent.What is the firm's weighted average cost of capital?

Accepted Answer

R_E = [($1.64 × 1.028)/$36] + 0.028 = 0.074831R_p = (0.06 × $100)/$51 = 0.117647 WACC = ($2,088,000/$3,458,250)(0.074831) + ($612,000/$3,458,250)(0.117647) + ($758,250/$3,458,250)(0.078814)(1 - 0.34) = 7.74 percent

Quiz 12: Cost of Capital