### BA 540 Chapter 11 – Calculating the Cost of Capital

LG1 11-1 How would you handle calculating the cost of capital if a firm were planning to issue two different classes of common stock?

LG2 11-2 Why don’t we multiply the cost of preferred stock by one minus the tax rate, as we do for debt?

LG2 11-3 Expressing WACC in terms of *i _{E}*,

*i*, and

_{P}*i*, what is the theoretical minimum for the WACC?

_{D}LG3 11-4 Under what situations would you want to use the CAPM approach for estimating the component cost of equity? The constant-growth model?

LG3 11-5 Could you calculate the component cost of equity for a stock with nonconstant expected growth rates in dividends if you didn’t have the information necessary to compute the component cost using the CAPM? Why or why not?

LG4 11-6 Why do we use market-based weights instead of book-value-based weights when computing the WACC?

LG5 11-7 Suppose your firm wanted to expand into a new line of business quickly, and that management anticipated that the new line of business would constitute over 80 percent of your firm’s operations within three years. If the expansion was going to be financed partially with debt, would it still make sense to use the firm’s existing cost of debt, or should you compute a new rate of return for debt based on the new line of

?

business

LG6 11-8 Explain why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division.

LG7 11-9 When will the subjective approach to forming divisional WACCs be better than using the firm-wide WACC to evaluate all projects?

LG8 11-10 Suppose a new project was going to be financed partially with retained earnings. What flotation costs should you use for retained earnings?

LG3 11-1 **Cost of Equity** Diddy Corp. stock has a beta of 1.2, the current risk-free rate is 5 percent, and the expected return on the market is 13.5 percent. What is Diddy’s cost of equity?

LG3 11-2 **Cost of Equity** JaiLai Cos. stock has a beta of 0.9, the current risk-free rate is 6.2 percent, and the expected return on the market is 12 percent. What is JaiLai’s cost of equity?

LG3 11-3 **Cost of Debt** Oberon, Inc. has a $20 million (face value) 10-year bond issue selling for 97 percent of par that pays an annual coupon of 8.25 percent. What would be Oberon’s before-tax component cost of debt?

LG3 11-4 **Cost of Debt** KatyDid Clothes has a $150 million (face value) 30-year bond issue selling for 104 percent of par that carries a coupon rate of 11 percent, paid semiannually. What would be Katydid’s before-tax component cost of debt?

LG3 11-5 **Tax Rate** Suppose that LilyMac Photography expects EBIT to be approximately $200,000 per year for the foreseeable future, and that they have 1,000 ten-year, nine percent annual coupon bonds outstanding. What would the appropriate tax rate be for use in the calculation of the debt component of LilyMac’s WACC?

LG3 11-6 **Tax Rate** PDQ, Inc. expects EBIT to be approximately $11 million per year for the foreseeable future, and that they have 25,000 20-year, eight percent annual coupon bonds outstanding. What would the appropriate tax rate be for use in the calculation of the debt component of PDQ’s WACC?

LG3 11-7 **Cost of Preferred Stock** ILK has preferred stock selling for 97 percent of par that pays an eight percent annual coupon. What would be ILK’s component cost of preferred stock?

LG3 11-8 **Cost of Preferred Stock** Marme, Inc. has preferred stock selling for 96 percent of par that pays an 11 percent annual coupon. What would be Marme’s component cost of preferred stock?

LG4 11-9 **Weight of Equity **FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $27 per share, the preferred shares are selling for $14.50 per share, and the bonds are selling for 98 percent of par, what would be the weight used for equity in the computation of FarCry’s WACC?

LG4 11-10 **Weight of Equity** OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the common shares are selling for $17 per share, the preferred shares are selling for $26 per share, and the bonds are selling for 108 percent of par, what would be the weight used for equity in the computation of OMG’s WACC?

LG4 11-11 **Weight of Debt** FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $27 per share, the preferred shares are selling for $14.50 per share, and the bonds are selling for 98 percent of par, what weight should you use for debt in the computation of FarCry’s WACC?

LG4 11-12 **Weight of Debt** OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the common shares are selling for $27 per share, the preferred shares are selling for $26 per share, and the bonds are selling for 108 percent of par, what weight should you use for debt in the computation of OMG’s WACC?

LG4 11-13 **Weight of Preferred Stock** FarCry Industries, a maker of telecommunications equipment, has two million shares of common stock outstanding, one million shares of preferred stock outstanding, and 10,000 bonds. If the common shares sell for $27 per share, the preferred shares sell for $14.50 per share, and the bonds sell for 98 percent of par, what weight should you use for preferred stock in the computation of FarCry’s WACC?

LG4 11-14 **Weight of Preferred Stock** OMG Inc. has four million shares of common stock outstanding, three million shares of preferred stock outstanding, and 5,000bonds. If the common shares sell for $17 per share, the preferred shares sell for $16 per share, and the bonds sell for 108 percent of par, what weight should you use for preferred stock in the computation of OMG’s WACC?

LG2 11-15 **WACC** Suppose that TapDance, Inc.’s capital structure features 65 percent equity, 35 percent debt, and that its before-tax cost of debt is eight percent, while its cost of equity is 13 percent. If the appropriate weighted average tax rate is 34 percent, what will be TapDance’s WACC?

LG2 11-16 **WACC** Suppose that JB Cos. has a capital structure of 78 percent equity, 22 percent debt, and that its before-tax cost of debt is 11 percent while its cost of equity is 15 percent. If the appropriate weighted average tax rate is 25 percent, what will be JB’s WACC?

LG2 11-17 **WACC** Suppose that B2B, Inc. has a capital structure of 37 percent equity, 17 percent preferred stock, and 46 percent debt. If the before-tax component costs of equity, preferred stock and debt are 14.5 percent, 11 percent and 9.5 percent, respectively, what is B2B’s WACC if the firm faces an average tax rate of 30 percent?

LG2 11-18 **WACC** Suppose that MNINK Industries’ capital structure features 63 percent equity, seven percent preferred stock, and 30 percent debt. If the before-tax component costs of equity, preferred stock and debt are 11.60 percent, 9.5 percent , and nine percent, respectively, what is MNINK’s WACC if the firm faces an average tax rate of 34 percent?

LG3 11-19 **WACC** TAFKAP Industries has three million shares of stock outstanding selling at $17 per share and an issue of $20 million in 7.5 percent, annual coupon bonds with a maturity of 15 years, selling at 106 percent of par. If TAFKAP’s weighted average tax rate is 34 percent and its cost of equity is 14.5 percent, what is TAFKAP’s WACC?

LG3 11-20 **WACC** Johnny Cake Ltd. has ten million shares of stock outstanding selling at $23 per share and an issue of $50 million in nine percent, annual coupon bonds with a maturity of 17 years, selling at 93.5 percent of par. If Johnny Cake’s weighted average tax rate is 34 percent, its next dividend is expected to be $3 per share, and all future dividends are expected to grow at six percent per year, indefinitely, what is its WACC?

LG4 11-21 **WACC** **Weights **BetterPie Industries has three million shares of common stock outstanding, two million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $47 per share, the preferred shares are selling for $24.50 per share, and the bonds are selling for 99 percent of par, what would be the weights used in the calculation of BetterPie’s WACC?

LG4 11-22 **WACC** **Weights **WhackAmOle has two million shares of common stock outstanding, 1.5 million shares of preferred stock outstanding, and 50,000 bonds. If the common shares are selling for $63 per share, the preferred shares are selling for $52 per share, and the bonds are selling for 103 percent of par, what would be the weights used in the calculation of WhackAmOle’s WACC?

LG8 11-23 **Flotation Cost **Suppose that Brown-Murphies’ common shares sell for $19.50 per share, that the firm is expected to set their next annual dividend at $0.57 per share, and that all future dividends are expected to grow by four percent per year, indefinitely. If Brown-Murphies faces a flotation cost of 13 percent on new equity issues, what will be the flotation-adjusted cost of equity?

LG4 11-21 **WACC** **Weights **BetterPie Industries has three million shares of common stock outstanding, two million shares of preferred stock outstanding, and 10,000 bonds. If the common shares are selling for $47 per share, the preferred shares are selling for $24.50 per share, and the bonds are selling for 99 percent of par, what would be the weights used in the calculation of BetterPie’s WACC?

LG4 11-22 **WACC** **Weights **WhackAmOle has two million shares of common stock outstanding, 1.5 million shares of preferred stock outstanding, and 50,000 bonds. If the common shares are selling for $63 per share, the preferred shares are selling for $52 per share, and the bonds are selling for 103 percent of par, what would be the weights used in the calculation of WhackAmOle’s WACC?

LG8 11-23 **Flotation Cost **Suppose that Brown-Murphies’ common shares sell for $19.50 per share, that the firm is expected to set their next annual dividend at $0.57 per share, and that all future dividends are expected to grow by four percent per year, indefinitely. If Brown-Murphies faces a flotation cost of 13 percent on new equity issues, what will be the flotation-adjusted cost of equity?

LG2 11-24 **Flotation Cost **A firm is considering a project that will generate perpetual after-tax cash flows of $15,000 per year beginning next year. The project has the same risk as the firm’s overall operations and must be financed externally. Equity flotation costs 14 percent and debt issues cost 4 percent on an after-tax basis. The firm’s D/E ratio is 0.8. What is the most the firm can pay for the project and still earn its required return?

LG6 11-25 **Firm-Wide vs. Project-Specific WACCs **An all-equity firm is considering the projects shown below. The T-bill rate is four percent and the market risk premium is seven percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly rejected?

LG6 11-26 **Firm-Wide vs. Project-Specific WACCs **An all-equity firm is considering the projects shown below. The T-bill rate is four percent and the market risk premium is seven percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly accepted?

LG7 11-27 **Divisional WACCs **Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.6, 1.0, 1.3 and 1.6, respectively. If all current and future projects will be financed with half debt and half equity, and if the current cost of equity (based on an average firm beta of 1.0 and a current risk-free rate of seven percent) is 13 percent and the after-tax yield on the company’s bonds is eight percent, what will the WACCs be for each division?

LG7 11-28 **Divisional WACCs **Suppose your firm has decided to use a divisional WACC approach to analyze projects. The firm currently has four divisions, A through D, with average betas for each division of 0.9, 1.1, 1.3, and 1.5, respectively. If all current and future projects will be financed with 25 percent debt and 75 percent equity, and if the current cost of equity (based on an average firm beta of 1.2 and a current risk-free rate of four percent) is 12 percent and the after-tax yield on the company’s bonds is nine percent, what will the WACCs be for each division?

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