Tutorial

Topic 7: Cost of Capital

Question 1
ABC Company has debt with a yield to maturity of 5%, a cost of equity of 13%, and a cost of preferred
stock of 9%. The market value of its debt, preferred stock, and equity are $10 million, $3 million, and
$15 million respectively, and its tax rate is 40%. What is the firms WACC?

Question 2
Aspen Inc. is planning to issue new debt; to estimate its cost, historical data will be used. Aspens
outstanding debt has an annual coupon interest rate of 10%, pays interest semi-annually, has 20 years
to maturity, and is currently trading at $1,198 per bond. If Aspens tax rate is 35%, what is the after-
tax cost of debt?
In addition, Aspen is planning to issue $100 par value preferred stock with an $8.50 dividend payment.
The firm expects to receive $93 per share. What is the cost of preferred stock?
Aspen is currently selling at $40 per share, and an expected EPS at the end of year of $7.20, a dividend
payout ratio of 50%, and an expected growth rate of 4%. What is Aspens cost of equity?
If Aspens target capital structure is 20% debt, 10% preferred stock, and 70% equity, what is Aspens
opportunity cost of capital?

Question 3
M&A Corporation decides to issue a 10-year new bond to raise money for its expansion project. It is
going to be a $1,000 par value, 6 percent bond for $1,100; the premium is $100. A 3-percent flotation
cost on the face value will be charged by the investment banker who promotes the bond. The marginal
tax rate for M&A is 30%.

(a) Calculate the yield to maturity of the bond.

(b) Calculate the after-tax cost of debt for M&A.
(c) Assuming the cost of common stock for M&A is 20 percent, calculate the WACC for M&A with
proportion of debt and equity of 30% and 70% respectively.

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Question 4
ABC Company has the following capital structure, which it considers optimal:

Bonds, 7% (now selling at par) $300,000

Preferred stock, $5.00 240,000
Common stock 360,000

Dividend on common stock are currently $3 per share and are expected to grow at a constant rate of
6%. Market price for common stock is $40, and the preferred stock is selling at $50. Flotation cost on
new issues of common stock is 10%. The interest on bonds is paid annually. The companys tax rate is
40%.

Calculate:

(a) The cost of bonds

(b) The cost of preferred stock
(c) The cost of new common stock
(d) The WACC

Question 5
The following represents the financial information for V Company:

8,500,000 ordinary shares ($5 each) $42,500,000

10,000 debentures 10% (maturity 10 years) $10,000,000
20,000 preference shares 11% ($100 each) $20,000,000

The share price for the company is currently $25 per share. The expected dividend to be paid by the
company is $1.50 per share with a constant growth rate of 6%.

The market price for the preference share is $105 per share. And, the market price for the debentures
is $887.

The marginal tax rate for the company is 30%.

Calculate the WACC.

Question 6
Explain why the use of a divisional WACC is more appropriate than a firm-wide WACC in some
circumstances.

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