Chapter 11 – Calculating the Cost of Capital
CHAPTER 11 – CALCULATING THE COST OF CAPITAL
Questions
LG1 1. How would you handle calculating the cost of capital if a firm were planning to issue two
LG2 2. Why don’t we multiply the cost of preferred stock by one minus the tax rate, as we do for
LG2 3. Expressing WACC in terms of iE, iP, and iD, what is the theoretical minimum for the
LG3 4. Under what situations would you want to use the CAPM approach for estimating the
component cost of equity? The constant-growth model?
LG3 5. Could you calculate the component cost of equity for a stock with nonconstant expected
growth rates in dividends if you didn’t have the information necessary to compute the
LG4 6. Why do we use market-based weights instead of book-value-based weights when
computing the WACC?
11-1
LG5 7. Suppose your firm wanted to expand into a new line of business quickly, and that
management anticipated that the new line of business would constitute over 80 percent of
your firm’s operations within three years. If the expansion was going to be financed
partially with debt, would it still make sense to use the firm’s existing cost of debt, or
should you compute a new rate of return for debt based on the new line of business?
LG6 8. Explain why the divisional cost of capital approach may cause problems if new projects
are assigned to the wrong division.
LG7 9. When will the subjective approach to forming divisional WACCs be better than using the
firmwide WACC to evaluate all projects?
LG8 10. Suppose a new project was going to be financed partially with retained earnings. What
flotation costs should you use for retained earnings?
problems
basic problems
LG3 11-1 Cost of Equity Diddy Corp. stock has a beta of 1.2, the current risk-free rate is 5 percent,
and the expected return on the market is 13.5 percent. What is Diddy’s cost of equity?
Chapter 11 – Calculating the Cost of Capital
LG3 11-6 Tax Rate PDQ, Inc. expects EBIT to be approximately $11 million per year for the
foreseeable future, and that they have 25,000 20-year, 8 percent annual coupon bonds
outstanding. What would the appropriate tax rate be for use in the calculation of the debt
component of PDQ’s WACC?
Chapter 11 – Calculating the Cost of Capital
Chapter 11 – Calculating the Cost of Capital
Using the computation for debt weight given in example 11-5:
5,000 1.08 $1,000
4m $27 3m $26 5,000 1.08 $1,000
$5.4m
$191.4m
0.0282, or 2.82%
D
E P D
´ ´
=
+ + ´ + ´ + ´ ´
=
=
LG4 11-13 Weight of Preferred Stock FarCry Industries, a maker of telecommunications
equipment, has two million shares of common stock outstanding, one million shares of
preferred stock outstanding, and 10,000 bonds. If the common shares sell for $27 per
share, the preferred shares sell for $14.50 per share, and the bonds sell for 98 percent of
par, what weight should you use for preferred stock in the computation of FarCry’s
WACC?
Using the computation for preferred weight given in equation 11-1:
2m $27
2m $27 1m $14.50 10,000 .98 $1, 000
$14.5m
$78.3m
0.1852, or 18.52%
P
E P D
´
=
+ + ´ + ´ + ´ ´
=
=
LG4 11-14 Weight of Preferred Stock OMG Inc. has four million shares of common stock
outstanding, three million shares of preferred stock outstanding, and 5,000 bonds. If the
common shares sell for $17 per share, the preferred shares sell for $16 per share, and the
bonds sell for 108 percent of par, what weight should you use for preferred stock in the
computation of OMG’s WACC?
4m $17 3m $16 5,000 1.08 $1,000
$121.4m
0.3954, or 39.54%
P
E P D
=
+ + ´ + ´ + ´ ´
=
=
Chapter 11 – Calculating the Cost of Capital
LG3 11-19 WACC TAFKAP Industries has three million shares of stock outstanding selling at $17
per share and an issue of $20 million in 7.5 percent, annual coupon bonds with a maturity
of 15 years, selling at 106 percent of par. If TAFKAP’s weighted average tax rate is 34
percent and its cost of equity is 14.5 percent, what is TAFKAP’s WACC?