Finance Chapter 10 if the company were to sell a new preferred issue, it would incur a flotation cost

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

in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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