11-11. Solution:
Terrier Company
a. Kd = Yield (1 – T)
b. Kd(new) = Yield (1 – T)
c. It has gone up. The before-tax yield is lower, but the lower
12. Real-world example and cost of debt (LO11-3) KeySpan Corp. is planning to issue debt
that will mature in 2035. In many respects, the issue is similar to the currently outstanding
debt of the corporation.
a. Using Table 11-3, identify the yield to maturity on similarly outstanding debt for the
firm in terms of maturity.
b. Assume that because the new debt will be issued at par, the required yield to maturity
will be 0.15 percent higher than the value determined in part a. Add this factor to the
answer in a. (New issues sold at par sometimes require a slightly higher yield than
older seasoned issues because there are fewer tax advantages and more financial
leverage that increase company risk.)
c. If the firm is in a 30 percent tax bracket, what is the aftertax cost of debt?
11-12. Solution:
KeySpan Corp. 2035
a. 4.32%
13. Cost of preferred stock (LO11-3) Medco Corporation can sell preferred stock for $90
with an estimated flotation cost of $2. It is anticipated the preferred stock will pay $8 per
share in dividends.
a. Compute the cost of preferred stock for Medco Corp.
b. Do we need to make a tax adjustment for the issuing firm?
11-13. Solution:
Medco Corporation
a.
$8 $8 9.09%
$90 $2 $88
p
p
p
D
KP F
=–
= = =
–
b. No tax adjustment is required. Preferred stock dividends are
14. Wallace Container Company issued $100 par value preferred stock 12 years ago. The stock
provided a 9 percent yield at the time of issue. The preferred stock is now selling for $72.
What is the current yield or cost of the preferred stock? (Disregard flotation costs.)
11-14. Solution:
Wallace Container Company
$9
Yield = 12.5%
$72
p
p
D
D= =
15. Comparison of the costs of debt and preferred stock (LO11-3) The treasurer of Riley
Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even
before making the calculations, she assumes the aftertax cost of debt is at least 3 percent
less than that for preferred stock. Based on the following facts, is she correct?
Debt can be issued at a yield of 11.0 percent, and the corporate tax rate is 20 percent.
Preferred stock will be priced at $60 and pay a dividend of $6.40. The flotation cost on the
preferred stock is $6.
11-15. Solution:
Riley Coal Inc.
Aftertax cost of debt
Yield (1 )
=11.0%(1 .20) = 11.0% (.80) = 8.80%
d
K T= –
–
Aftertax cost of preferred stock
$6.40 $6.40 11.85%
$60 $6 $54
p
p
p
D
KP F
= = = =
– –
Yes, the treasurer is correct. The difference is 3.05% (8.80%
versus 11.85%).
16. Murray Motor Company wants you to calculate its cost of common stock. During the next
12 months, the company expects to pay dividends (D1) of $2.50 per share, and the current
price of its common stock is $50 per share. The expected growth rate is 8 percent.
a. Compute the cost of retained earnings (Ke). Use Formula 11-6.
b. If a $3 flotation cost is involved, compute the cost of new common stock (Kn).
Use Formula 11-7.
11-16. Solution:
Murray Motor Co.
a.
1
0
$2.50
= 8% 5% 8% 13%
$50
e
D
K g
P
= +
+ = + =
b.
1
0
$2.50 $2.50
= 8% 8%
$50 $3 $47
5.32% 8% 13.32%
n
D
K g
P F
= +
–
+ = +
–
= + =
17. Costs of retained earnings and new common stock (LO11-3) Compute Ke and Kn under
the following circumstances:
a.D1 = $5.00, P0 = $70, g = 8%, F = $7.00.
b.D1 = $0.22, P0 = $28, g = 7%, F = $2.50.
c.E1 (earnings at the end of period one) = $7, payout ratio equals 40 percent, P0 = $30,
g = 6.0%, F = $2.20.
d.D0 (dividend at the beginning of the first period) = $6, growth rate for dividends and
earnings (g) = 7%, P0 = $60, F = $3.
11-17. Solution:
a.
b.
1
0
1
0
$.22
= 7% .79% 7% 7.79%
$28
$.22 $.22
= 7% 7%
$28 $2.50 $25.50
.86% 7% 7.86%
e
n
D
K g
P
D
K g
P F
= +
+ = + =
= +
–
+ = +
–
= + =
c.
1 1
40% 40% $7.00 $2.80D E= ´ = ´ =
1
0
1
0
$2.80
= 6.00% 9.33% 6.00% 15.33%
$30
$2.80
= 6.00%
$30 $2.20
$2.80 6.00% 10.07% 6.00% 16.07%
$27.80
e
n
D
K g
P
D
K g
P F
= +
+ = + =
= +
–
+
–
= + = + =
d.
1 0
1
0
1
0
(1 ) $6.00 (1.07) $6.42
$6.42 7% 10.7% 7% 17.7%
$60
$6.42 $6.42
7% 7%
$60 $3 $57
11.26% 7% 18.26%
e
n
D D g
D
K g
P
D
K g
P F
= + = ´ =
= +
= + = + =
= +
–
= + = +
–
= + =
18. Business has been good for Keystone Control Systems, as indicated by the four-year
growth in earnings per share. The earnings have grown from $1.00 to $1.63.
a. Use Appendix A at the back of the text to determine the compound annual rate of
growth in earnings (n = 4).
b. Based on the growth rate determined in part a, project earnings for next year (E1).
Round to two places to the right of the decimal point.
c. Assume the dividend payout ratio is 40 percent. Compute D1. Round to two places to
the right of the decimal point.
d. The current price of the stock is $50. Using the growth rate (g) from part a and (D1)
from part c, compute Ke.
e. If the flotation cost is $3.75, compute the cost of new common stock (Kn).
11-18. Solution:
Keystone Control Systems
a.
IF
$1.63 FV 1.63 ( 4) 13%
1.00 n i= = =
b.
1 0
$1.63 (1.13)
=
19. Global Technology’s capital structure is as follows:
Debt………………………. 35%
Preferred stock……….. 15
Common equity………. 50
The aftertax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; and the
cost of common equity (in the form of retained earnings) is 13.5 percent.
Calculate Global Technology’s weighted average cost of capital in a manner similar to
Table 11-1.
11-19. Solution:
Global Technology
Cost
(aftertax) Weights
Weighted
Cost
20. Evans Technology has the following capital structure.
The aftertax cost of debt is 6 percent; and the cost of common equity (in the form of
retained earnings) is 13 percent.
a. What is the firm’s weighted average cost of capital?
b. An outside consultant has suggested that because debt is cheaper than equity, the
firm should switch to a capital structure that is 50 percent debt and 50 percent
equity. Under this new and more debt-oriented arrangement, the aftertax cost of
debt is 7 percent, and the cost of common equity (in the form of retained earnings)
is 15 percent. Recalculate the firm’s weighted average cost of capital.
c. Which plan is optimal in terms of minimizing the weighted average cost of
capital?
11-20. Solution:
Evans Technology
a. Cost
(aftertax) Weights
Weighted
Cost
of capital (Ka)……………………….
b. Cost
(aftertax) Weights
Weighted
Cost
of capital (Ka)……………………….
c. The plan presented in part a is the better alternative. Even
21. Weighted average cost of capital (LO11-1) Sauer Milk Inc. wants to determine the
minimum cost of capital point for the firm. Assume it is considering the following financial
plans:
Cost
(aftertax) Weights
Plan A
Debt…………………………………. 4.0% 30%
Preferred stock………………….. 8.0 15
Common equity…………………. 12.0 55
Plan B
Debt…………………………………. 4.5% 40%
Preferred stock………………….. 8.5 15
Common equity…………………. 13.0 45
Plan C
Debt…………………………………. 5.0% 45%
Preferred stock………………….. 18.7 15
Common equity…………………. 12.8 40
Plan D
Debt…………………………………. 12.0% 50%
Preferred stock………………….. 19.2 15
Common equity…………………. 14.5 35
a. Which of the four plans has the lowest weighted average cost of capital? (Round to
two places to the right of the decimal point.)
b. Briefly discuss the results from Plan C and Plan D, and why one is better than
the other.