Chapter 9

The Cost of Capital

9-1 Calculate the after-tax cost of debt under each of the following conditions:
a. Interest rate of 13%, tax rate of 0%
b. Interest rate of 13%, tax rate of 20%
c. Interest rate of 13%, tax rate of 35%
a. rd(1 - T) = 13%(1 - 0) = 13.00%.

b. rd(1 - T) = 13%(0.80) = 10.40%.

c. rd(1 - T) = 13%(0.65) = 8.45%.

9-2 LL Incorporated’s currently outstanding 11% coupon bonds have a

yield to maturity of 8%. LL believes it could issue new bonds at par that would
provide a similar yield to maturity. If its marginal tax rate is 35%, what is LL’s
after-tax cost of debt?

rd(1 - T) = 0.08(0.65) = 5.2%.

9-3 Duggins Veterinary Supplies can issue perpetual preferred stock at a price of
$50 a share with an annual dividend of $4.50 a share. Ignoring flotation costs, what
is the company’s cost of preferred stock, rps?

Vps = $50; Dps = $4.50; F = 0%; rps = ?

D ps
rps =
V ps(1−F )
$ 4.50
= $50 (1−0.0)
= 9%.

9-4 Burnwood Tech plans to issue some $60 par preferred stock with a 6%
dividend. A similar stock is selling on the market for $70. Burnwood must pay
flotation costs of 5% of the issue price. What is the cost of the preferred stock?
$ 60(0 .06) $3.60
rps = $70 .00(1−0.05 ) = $66.50 = 5.41%.
9-5 Summerdahl Resort’s common stock is currently trading at $36 a share. The
stock is expected to pay a dividend of $3.00 a share at the end of the year (D1 =
$3.00), and the dividend is expected to grow at a constant rate of 5% a year. What
is its cost of common equity?
P0 = $36; D1 = $3.00; g = 5%; rs = ?

D1
rs = P0 + g = ($3.00/$36.00) + 0.05 = 13.33%.

9-6 Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4%
and the yield on a 10-year T-bond is 6%. The market risk premium is 5.5%, and
the return on an average stock in the market last year was 15%. What is the
estimated cost of common equity using the CAPM?
rs = rRF + bi(RPM) = 0.06 + 0.8(0.055) = 10.4%.
9-7 Shi Importer’s balance sheet shows $300 million in debt, $50 million in
preferred stock, and $250 million in total common equity. Shi’s tax rate is 40%, rd
= 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt,
5% preferred stock, and 65% common stock, what is its WACC?

30% Debt; 5% Preferred Stock; 65% Equity; rd = 6%; T = 40%; rps = 5.8%; rs = 12%.

WACC = (wd)(rd)(1 - T) + (wps)(rps) + (ws)(rs)

WACC = 0.30(0.06)(1-0.40) + 0.05(0.058) + 0.65(0.12) = 9.17%.

9-8 David Ortiz Motors has a target capital structure of 40% debt and 60%
equity. The yield to maturity on the company’s outstanding bonds is 9%, and the
company’s tax rate is 40%. Ortiz’s CFO has calculated the company’s WACC as
9.96%. What is the company’s cost of equity capital?
40% Debt; 60% Equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?

WACC = (wd)(rd)(1 - T) + (ws)(rs)

9.96% = (0.4)(9%)(1 - 0.4) + (0.6)rs
9.96% = 2.16% + 0.6rs
7.8% = 0.6rs
rs = 13%.
9-9 A company’s 6% coupon rate, semiannual payment, $1,000 par value bond that matures
in 30 years sells at a price of $515.16. The company’s federal-plus-state tax rate is 40%. What is
the firm’s after-tax component cost of debt for purposes of calculating the WACC? (Hint: Base
your answer on the nominal rate.)

Enter these values: N = 60, PV = -515.16, PMT = 30, and FV = 1000, to get I = 6% = periodic
rate. The nominal rate is 6%(2) = 12%, and the after-tax component cost of debt is
12%(0.6) = 7.2%.

CP + (FV + PV) / n
YTM = ________________
(FV + PV) / 2

9-10 The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per
year in the future. Shelby’s common stock sells for $23 per share, its last dividend was $2.00,
and the company will pay a dividend of $2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market
is 13%, then what would be the firm’s cost of equity based on the CAPM approach?
c. If the firm’s bonds earn a return of 12%, then what would be your estimate of rs
using the over-own-bond-yield-plus-judgmental-risk-premium approach?
(Hint: Use the midpoint of the risk premium range.)
d. On the basis of the results of parts a through c, what would be your estimate of
Shelby’s cost of equity?

D1 $2.14
a. rs = P0 + g = $23 + 7% = 9.3% + 7% = 16.3%.

b. rs = rRF + (rM - rRF)b

= 9% + (13% - 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. rs = Bond rate + Risk premium = 12% + 4% = 16%.

d. The bond-yield-plus-judgmental-risk-premium approach and the CAPM method both

resulted in lower cost of equity values than the dividend growth approach. The firm's
cost of equity should be estimated to be about 15.9%, which is the average of the
three methods.
9-11 Radon Homes’ current EPS is $6.50. It was $4.42 five years ago. The company pays out
40% of its earnings as dividends, and the stock sells for $36.
a. Calculate the historical growth rate in earnings. (Hint: This is a 5-year growth period.)
b. Calculate the next expected dividend per share, D1. (Hint: D0 = 0.4($6.50) =
$2.60.) Assume that the past growth rate will continue.
c. What is Radon Homes’ cost of equity, rs?

a. $6.50 = $4.42(1+g)5
(1+g)5 = $6.50/$4.42 = 1.471
(1+g) = 1.471(1/5) = 1.080
g = 8%.

Alternatively, with a financial calculator, input N = 5, PV = -4.42, PMT = 0,

FV = 6.50, and then solve for I/YR = 8.02%  8%.

b. D1 = D0(1 + g) = $2.60(1.08) = $2.81.

c. rs = D1/P0 + g = $2.81/$36.00 + 8% = 15.81%.

9-12 Spencer Supplies’ stock is currently selling for $60 a share. The firm is expected to
earn $5.40 per share this year and to pay a year-end dividend of $3.60.
a. If investors require a 9% return, what rate of growth must be expected for
Spencer?
b. If Spencer reinvests earnings in projects with average returns equal to the
stock’s expected rate of return, then what will be next year’s EPS?
(Hint: g = ROE × Retention ratio.)

D1
a. rs = P0 +g
$3.60
0.09 = $60.00 + g
0.09 = 0.06 + g
g = 3%.

b. EPS1 = EPS0(1 + g) = $5.40(1.03) = $5.562.

9-13 Messman Manufacturing will issue common stock to the public for $30. The expected
dividend and the growth in dividends are $3.00 per share and 5%, respectively. If the flotation
cost is 10% of the issue’s gross proceeds, what is the cost of external equity, re?

P0 = $30; D1 = $3.00; g = 5%; F = 10%; rs = ?

rs = [D1/(1-F) P0] + g = [$3/(1-0.10)($30)] + 0.05 = 16.1%.

9-14 Suppose a company will issue new 20-year debt with a par value of $1,000 and a coupon
rate of 9%, paid annually. The tax rate is 40%. If the flotation cost is 2% of the
issue proceeds, then what is the after-tax cost of debt? Disregard the tax shield from
the amortization of flotation costs.

Enter these values: N = 20, PV =1,000(1-0.02) = 980, PMT = -90(1- 0.4)=-54, and
FV = -1000, to get I/YR = 5.57%, which is the after-tax component cost of debt.
9-15 On January 1, the total market value of the Tysseland Company was $60 million.
During the year, the company plans to raise and invest $30 million in new projects.
The firm’s present market value capital structure, shown below, is considered to be
optimal. There is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock
is currently selling at $30 a share. The stockholders’ required rate of return is estimated
to be 12%, consisting of a dividend yield of 4% and an expected constant
growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is
$1.20/$30 = 4%.) The marginal tax rate is 40%.

a. In order to maintain the present capital structure, how much of the new investment
must be financed by common equity?
b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital
structure without issuing additional shares of equity, what is its WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue
new shares of stock. Qualitatively speaking, what will happen to the WACC? No
numbers are required to answer this question.

a. Common equity needed:

0.5($30,000,000) = $15,000,000.

b. Cost using rs:

After-Tax
Percent Cost = Product
Debt 0.50 4.8%* 2.4%
Common equity 0.50 12.0 6.0
WACC = 8.4%

*8%(1 - T) = 8%(0.6) = 4.8%.

c. ks and the WACC will increase due to the flotation costs of new equity.
9-16 The book and market value of the notes payable are $10,000,000.

The bonds have a value of

V = $60([1/0.10]-[1/(0.1*(1+0.10)20)]) + $1,000((1+0.10)-20)
= $60(8.5136) + $1,000(0.1486)
= $510.82 + $148.60 = $659.42.

Alternatively, using a financial calculator, input N = 20, I/YR = 10, PMT = 60, and FV =
1000 to arrive at a PV = $659.46.
The total market value of the long-term debt is 30,000($659.46) = $19,783,800.
There are 1 million shares of stock outstanding, and the stock sells for $60 per share.
Therefore, the market value of the equity is $60,000,000.
The market value capital structure is thus:

Short-term debt $10,000,000 11.14%

Long-term debt 19,783,800 22.03
Common equity 60,000,000 66.83
$89,783,800 100.00%
9-17 Several steps are involved in the solution of this problem. Our solution follows:

Step 1.

Establish a set of market value capital structure weights. In this case, A/P and accruals
should be disregarded because they are not sources of financing from investors. Instead
of being incorporated into the WACC, they are accounted for when calculating cash
flows. For this firm, short-term debt is used to finance seasonal goods, and the balance is
reduced to zero in off-seasons. Therefore, this is not a source of permanent financing. and
should be disregarded when calculating the WACC.

Debt:

The long-term debt has a market value found as follows:

40
∑ (1$.06
40 $ 1 , 000
+
)t (1 . 06)40
V0 = t=1 = $699,

or 0.699($30,000,000) = $20,970,000 in total. Notice that short-term debt is not included

in the capital structure for this company. We usually include short-term debt in the total
debt figure for calculating weights because in the absence of any other information, we
assume the short-term debt will be rolled over from year to year. In this case, however,
the company does not use short-term debt as a permanent source of financing. Indeed, as
stated in the problem, the short-term debt balance is zero off-season. In such a situation
neither the lender nor the company believes that the debt balance will be rolled over from
year to year as the loan is closed out each off-season and so it is not considered a
component of the capital structure.

Preferred Stock:

The preferred has a value of

$2
Pps = 0.11/ 4 = $72.73.

There are $5,000,000/$100 = 50,000 shares of preferred outstanding, so the total market
value of the preferred is

50,000($72.73) = $3,636,500.
Common Stock:

The market value of the common stock is

4,000,000($20) = $80,000,000.

Therefore, here is the firm's market value capital structure, which we assume to be
optimal:

Long-term debt $ 20,970,000 20.05%

Preferred stock 3,636,500 3.48
Common equity 80,000,000 76.47
$104,606,500 100.00%

We would round these weights to 20% debt, 4% preferred, and 76% common equity.

Step 2.

Establish cost rates for the various capital structure components.

Debt cost:

rd(1 - T) = 12%(0.6) = 7.2%.

Preferred stock cost:

Annual dividend on new preferred = 11%($100) = $11. Therefore,

rps = $11/$100(1 - 0.05) = $11/$95 = 11.6%.

Common equity cost:

There are three basic ways of estimating rs: CAPM, the dividend growth approach, and
judgmental risk premium over own bonds. None of the methods is very exact.
 CAPM:

We would use rRF = T-bond rate = 10%. For RP M, we would use 4.5% to 5.5%. For beta,
we would use a beta in the 1.3 to 1.7 range. Combining these values, we obtain this
range of values for rs:

Midpoint: rs = 10% + (5.0)(1.5) = 17.50%.

Dividend growth approach:

The company seems to be in a rapid, non-constant growth situation, but we do not have
the inputs necessary to develop a non-constant rs. Therefore, we will use the constant
growth model but temper our growth rate; that is, think of it as a long-term average g that
may well be higher in the immediate future than in the more distant future.

We could use as a growth estimator this method:

g = b(ROE) = 0.5(24%) = 12%.

It would not be appropriate to base g on the 30% ROE, because investors do not expect
that rate.
Finally, we could use the analysts' forecasted g range, 10% to 15%. The dividend
yield is D1/P0. Assuming g = 12%,
DCF (ks) =
D1 $1 (1.12)
P0 = $ 20 + g = 5.6% + 12.5% = 18.1%

Generalized risk premium (Own Bond yield plus risk premium:

We take avg. of 6 and 4 risk premiums which is 5.

Midpoint: rs = 12% + 5% = 17%.

Based on the three midpoint estimates, we have rs in this range:

CAPM 17.5%
Dividend growth 18.1%
Risk Premium 17.0%

Step 3.

Calculate the WACC:

WACC = (D/V)(rdAT) + (P/V)(rps) + (S/V)(rs or re)

= 0.20(rdAT) + 0.04(rps) + 0.76(rs or re).
It would be appropriate to calculate a range of WACCs based on the ranges of component
costs, but to save time, we shall assume r dAT = 7.2%, rps = 11.6%, and rs = 17.5%. With
these cost rates, here is the WACC calculation:

WACC = 0.2(7.2%) + 0.04(11.6%) + 0.76(17.5%) = 15.2%.