Chapter 10

1. Which of the following statements is CORRECT?

a. A change in a companys target capital structure cannot affect its WACC.

b. WACC calculations should be based on the before-tax costs of all the
individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce
the WACC.
d. If a companys tax rate increases, then, all else equal, its weighted average
cost of capital will decline.
e. An increase in the risk-free rate will normally lower the marginal costs of both
debt and equity financing.
d

Statement d is true, because the cost of debt for WACC purposes = rd(1 T), so if
T increases, then
rd(1 T) declines.

2. For a company whose target capital structure calls for 50% debt and 50%
common equity, which of the following statements is CORRECT?

a. The interest rate used to calculate the WACC is the average after-tax cost of
all the company's outstanding debt as shown on its balance sheet.
b. The WACC is calculated on a before-tax basis.
c. The WACC exceeds the cost of equity.
d. The cost of equity is always equal to or greater than the cost of debt.
e. The cost of retained earnings typically exceeds the cost of new common stock.
d

Statement d is true, because equity is more risky than debt and hence investors
require a higher return on equity. Also, interest on debt is deductible, and this
further reduces the cost of debt. The other statements are false.

3. Several years ago the Jakob Company sold a $1,000 par value, noncallable bond
that now has 20 years to maturity and a 7.00% annual coupon that is paid
semiannually. The bond currently sells for $925, and the companys tax rate is
40%. What is the component cost of debt for use in the WACC calculation?

a. 4.28%
b. 4.46%
c. 4.65%
d. 4.83%
e. 5.03%
c
 Coupon rate 7.00%
Periods/year 2
Maturity (yr) 20
Bond price $925.00
Par value $1,000
Tax rate 40%

Calculator inputs:
N = 2 20 40
PV = Bond's price -$925.00
PMT = Coupon rate Par/2 $35
FV = Par = Maturity value $1,000
I/YR 3.87%
Times periods/yr = before-tax cost of debt 7.74%
= After-tax cost of debt (A-T rd) for use in WACC 4.65%

4. Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital.
You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00%
(constant). Based on the DCF approach, what is the cost of equity from retained
earnings?

a. 9.29%
b. 9.68%
c. 10.08%
d. 10.50%
e. 10.92%
d

D0 $0.90
P0 $27.50
g 7.00%
D1 = D0 (1 + g) $0.963
rs = D1/P0 + g 10.50%

5. Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its
expected dividend payout ratio is 65%, its expected constant dividend growth rate
is 6.0%, and its common stock currently sells for $32.50 per share. New stock
can be sold to the public at the current price, but a flotation cost of 5% would be
incurred. What would be the cost of equity from new common stock?

a. 12.70%
b. 13.37%
c. 14.04%
d. 14.74%
e. 15.48%
 b

Expected EPS1 $3.50

Payout ratio 65%
Expected dividend, D1 = EPS Payout $2.275
Current stock price $32.50
g 6.00%
F 5.00%
re = D1/(P0 (1 F)) + g 13.37%

6. Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 =
$2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and
the common stock currently sells for $52.50 a share. The before-tax cost of debt
is 7.50%, and the tax rate is 40%. The target capital structure consists of 45%
debt and 55% common equity. What is the companys WACC if all the equity
used is from retained earnings?

a. 7.07%
b. 7.36%
c. 7.67%
d. 7.98%
e. 8.29%
c

D1 $2.50
g 5.50%
P0 $52.50
rd 7.50%
Tax rate 40%
Weight debt 45%
Weight equity 55%
rd(1 T) 4.50%
rs = D1/P0 + g 10.26%
WACC = wd(rd)(1 T) + wc(rs) = 7.67%

7. You were hired as a consultant to Quigley Company, whose target capital

structure is 35% debt, 10% preferred, and 55% common equity. The interest rate
on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained
earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new
stock. What is Quigley's WACC?

a. 8.15%
b. 8.48%
c. 8.82%
d. 9.17%
e. 9.54%
a

Tax rate = 40%

Weights rd AT Costs
Debt 35% 6.50% 3.90%
Preferred 10% 6.00%
Common 55% 11.25%