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Chapter 10: Cost of Capital M/C Problems Page 371
Multiple Choice: Problems
65. Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and
it pays an $8.50 annual dividend. If the company were to sell a new
preferred issue, it would incur a flotation cost of 4.00% of the price
paid by investors. What is the company's cost of preferred stock for
use in calculating the WACC?
a. 8.72%
b. 9.08%
c. 9.44%
d. 9.82%
e. 10.22%
66. A company’s perpetual preferred stock currently sells for $92.50 per
share, and it pays an $8.00 annual dividend. If the company were to
sell a new preferred issue, it would incur a flotation cost of 5.00% of
the issue price. What is the firm's cost of preferred stock?
a. 7.81%
b. 8.22%
c. 8.65%
d. 9.10%
e. 9.56%
67. O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b =
1.05. What is the firm's cost of equity from retained earnings based
on the CAPM?
a. 11.30%
b. 11.64%
c. 11.99%
d. 12.35%
e. 12.72%
68. Scanlon Inc.'s CFO hired you as a consultant to help her estimate the
cost of capital. You have been provided with the following data: rRF =
4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is
the cost of equity from retained earnings?
a. 9.67%
b. 9.97%
c. 10.28%
d. 10.60%
e. 10.93%
Page 372 M/C Problems Chapter 10: Cost of Capital
69. Assume that you are a consultant to Broske Inc., and you have been
provided with the following data: D1 = $0.67; P0 = $27.50; and g =
8.00% (constant). What is the cost of equity from retained earnings
based on the DCF approach?
a. 9.42%
b. 9.91%
c. 10.44%
d. 10.96%
e. 11.51%
70. Teall Development Company hired you as a consultant to help them
estimate its cost of capital. You have been provided with the
following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant).
Based on the DCF approach, what is the cost of equity from retained
earnings?
a. 11.10%
b. 11.68%
c. 12.30%
d. 12.94%
e. 13.59%
71. A. Butcher Timber Company hired your consulting firm to help them
estimate the cost of equity. The yield on the firm's bonds is 8.75%,
and your firm's economists believe that the cost of equity can be
estimated using a risk premium of 3.85% over a firm's own cost of debt.
What is an estimate of the firm's cost of equity from retained
earnings?
a. 12.60%
b. 13.10%
c. 13.63%
d. 14.17%
e. 14.74%
72. You were hired as a consultant to Giambono Company, whose target
capital structure is 40% debt, 15% preferred, and 45% common equity.
The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and
the cost of retained earnings is 12.75%. The firm will not be issuing
any new stock. What is its WACC?
a. 8.98%
b. 9.26%
c. 9.54%
d. 9.83%
e. 10.12%
Chapter 10: Cost of Capital M/C Problems Page 373
73. To help finance a major expansion, Castro Chemical Company sold a
noncallable bond several years ago that now has 20 years to maturity.
This bond has a 9.25% annual coupon, paid semiannually, sells at a
price of $1,075, and has a par value of $1,000. If the firm's tax rate
is 40%, what is the component cost of debt for use in the WACC
calculation?
a. 4.35%
b. 4.58%
c. 4.83%
d. 5.08%
e. 5.33%
74. 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 company’s 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%
75. 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%
76. Rivoli Inc. hired you as a consultant to help estimate its cost of
capital. You have been provided with the following data: D0 = $0.80;
P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what
is the cost of equity from retained earnings?
a. 10.69%
b. 11.25%
c. 11.84%
d. 12.43%
e. 13.05%
Page 374 M/C Problems Chapter 10: Cost of Capital
77. Trahan Lumber Company hired you to help estimate its cost of capital.
You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00%
(constant); and F = 6.00%. What is the cost of equity raised by
selling new common stock?
a. 9.06%
b. 9.44%
c. 9.84%
d. 10.23%
e. 10.64%
78. You were recently hired by Scheuer Media Inc. to estimate its cost of
capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g =
7.00% (constant); and F = 5.00%. What is the cost of equity raised by
selling new common stock?
a. 10.77%
b. 11.33%
c. 11.90%
d. 12.50%
e. 13.12%
79. 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%
80. 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 company’s 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%
Chapter 10: Cost of Capital M/C Problems Page 375
81. 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%
82. Keys Printing plans to issue a $1,000 par value, 20-year noncallable
bond with a 7.00% annual coupon, paid semiannually. The company's
marginal tax rate is 40.00%, but Congress is considering a change in
the corporate tax rate to 30.00%. By how much would the component cost
of debt used to calculate the WACC change if the new tax rate was
adopted?
a. 0.57%
b. 0.63%
c. 0.70%
d. 0.77%
e. 0.85%
83. S. Bouchard and Company hired you as a consultant to help estimate its
cost of capital. You have obtained the following data: D0 = $0.85; P0
= $22.00; and g = 6.00% (constant). The CEO thinks, however, that the
stock price is temporarily depressed, and that it will soon rise to
$40.00. Based on the DCF approach, by how much would the cost of
equity from retained earnings change if the stock price changes as the
CEO expects?
a. -1.49%
b. -1.66%
c. -1.84%
d. -2.03%
e. -2.23%
84. Sapp Trucking’s balance sheet shows a total of noncallable $45 million
long-term debt with a coupon rate of 7.00% and a yield to maturity of
6.00%. This debt currently has a market value of $50 million. The
balance sheet also shows that the company has 10 million shares of
common stock, and the book value of the common equity (common stock
plus retained earnings) is $65 million. The current stock price is
$22.50 per share; stockholders' required return, rs, is 14.00%; and the
firm's tax rate is 40%. The CFO thinks the WACC should be based on
market value weights, but the president thinks book weights are more
appropriate. What is the difference between these two WACCs?
Page 376 M/C Problems Chapter 10: Cost of Capital
a. 1.55%
b. 1.72%
c. 1.91%
d. 2.13%
e. 2.36%
85. The CFO of Lenox Industries hired you as a consultant to help estimate
its cost of capital. You have obtained the following data: (1) rd =
yield on the firm’s bonds = 7.00% and the risk premium over its own
debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 =
$1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to
estimate the cost of equity based on the three most commonly used
methods and then to indicate the difference between the highest and
lowest of these estimates. What is that difference?
a. 1.13%
b. 1.50%
c. 1.88%
d. 2.34%
e. 2.58%
86. Eakins Inc.’s common stock currently sells for $45.00 per share, the
company expects to earn $2.75 per share during the current year, its
expected payout ratio is 70%, and its expected constant growth rate is
6.00%. New stock can be sold to the public at the current price, but a
flotation cost of 8% would be incurred. By how much would the cost of
new stock exceed the cost of retained earnings?
a. 0.09%
b. 0.19%
c. 0.37%
d. 0.56%
e. 0.84%
87. Bolster Foods’ (BF) balance sheet shows a total of $25 million long-
term debt with a coupon rate of 8.50%. The yield to maturity on this
debt is 8.00%, and the debt has a total current market value of $27
million. The balance sheet also shows that the company has 10 million
shares of stock, and the stock has a book value per share of $5.00.
The current stock price is $20.00 per share, and stockholders' required
rate of return, rs, is 12.25%. The company recently decided that its
target capital structure should have 35% debt, with the balance being
common equity. The tax rate is 40%. Calculate WACCs based on book,
market, and target capital structures, and then find the sum of these
three WACCs.
a. 28.36%
b. 29.54%
c. 30.77%
d. 32.00%
e. 33.28%
88. Daves Inc. recently hired you as a consultant to estimate the company’s
WACC. You have obtained the following information. (1) The firm's
noncallable bonds mature in 20 years, have an 8.00% annual coupon, a
par value of $1,000, and a market price of $1,050.00. (2) The
company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market
risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target
capital structure consists of 35% debt and the balance is common
equity. The firm uses the CAPM to estimate the cost of equity, and it
does not expect to issue any new common stock. What is its WACC?
a. 7.16%
b. 7.54%
c. 7.93%
d. 8.35%
e. 8.79%
89. Assume that you are on the financial staff of Vanderheiden Inc., and you
have collected the following data: The yield on the company’s outstanding
bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a
share, the dividend is expected to grow at a constant rate of 6.00% a
year, the price of the stock is $15.00 per share, the flotation cost for
selling new shares is F = 10%, and the target capital structure is 45%
debt and 55% common equity. What is the firm's WACC, assuming it must
issue new stock to finance its capital budget?
a. 6.89%
b. 7.26%
c. 7.64%
d. 8.04%
e. 8.44%
90. Vang Enterprises, which is debt-free and finances only with equity from
retained earnings, is considering 7 equal sized capital budgeting
projects. Its CFO hired you to assist in deciding whether none, some, or
all of the projects should be accepted. You have the following
information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or
subtracts a specified percentage to the corporate WACC when it evaluates
projects that have above- or below-average risk. Data on the 7 projects
are shown below. If these are the only projects under consideration, how
large should the capital budget be?
Risk Expected Cost
Project Risk Factor Return (Millions)
1 Very low -2.00% 7.60% $25.0
2 Low -1.00% 9.15% $25.0
3 Average 0.00% 10.10% $25.0
4 High 1.00% 10.40% $25.0
5 Very high 2.00% 10.80% $25.0
6 Very high 2.00% 10.90% $25.0
7 Very high 2.00% 13.00% $25.0
Page 378 M/C Problems Chapter 10: Cost of Capital
b. $ 75
c. $ 50
d. $ 25
e. $ 0
Multiple Part:
(The following information applies to Problems 91, 92, 93, and 94.)
Assume that you have been hired as a consultant by CGT, a major producer of
chemicals and plastics, including plastic grocery bags, styrofoam cups, and
fertilizers, to estimate the firm's weighted average cost of capital. The
balance sheet and some other information are provided below.
Assets
Current assets $ 38,000,000
Net plant, property, and equipment 101,000,000
Total assets $139,000,000
Liabilities and Equity
Accounts payable $ 10,000,000
Accruals 9,000,000
Current liabilities $ 19,000,000
Long-term debt (40,000 bonds, $1,000 par value) 40,000,000
Total liabilities $ 59,000,000
Common stock (10,000,000 shares) 30,000,000
Retained earnings 50,000,000
Total shareholders' equity 80,000,000
Total liabilities and shareholders' equity $139,000,000
The stock is currently selling for $15.25 per share, and its noncallable
$1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling
for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is
3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required
return on the stock market is 11.50%, but the market has had an average
annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.
91. What is the best estimate of the after-tax cost of debt?
a. 4.64%
b. 4.88%
c. 5.14%
d. 5.40%
e. 5.67%
92. Based on the CAPM, what is the firm's cost of equity?
a. 11.15%
b. 11.73%
c. 12.35%
d. 13.00%
e. 13.65%
Chapter 10: Cost of Capital M/C Problems Page 379
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93. Which of the following is the best estimate for the weight of debt for
use in calculating the WACC?
a. 18.67%
b. 19.60%
c. 20.58%
d. 21.61%
e. 22.69%
94. What is the best estimate of the firm's WACC?
a. 10.85%
b. 11.19%
c. 11.53%
d. 11.88%
e. 12.24%
truly correct.
CHAPTER 10
ANSWERS AND SOLUTIONS
