6/12/2017 Fin Man 11 - Google Docs

Financial Management
Chapter 11

page 365
11-1
AFTER-TAX COST OF DEBT The Heuser Company's currently outstanding bonds
have a 10% coupon and a 12% yield to maturity. Heuser 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 Heuser's after-tax cost of debt?

The new bonds would have a coupon rate of 12% to be issued at par.
The after tax cost of debt = Before tax cost x (1-tax rate)After tax cost =
12% X (1-0.35) = 7.8%

11-2
COST OF PREFERRED STOCK Tunney Industries can issue perpetual preferred stock
at a price of $ 47.50 a share.The stock would pay a constant annual dividend of $ 3.80
a share. What is the company's cost of preferred stock, rp?
Cost of preferred stock rp = Dividend/ current price of share
= 3.80/47.50
= 0.08 or 8%


11-3
COST OF COMMON EQUITY Percy Motors has a target capital structure of 40% debt
and 60% common equity, with no preferred stock. The yield to maturity on the
company's outstanding bonds is 9%, and its tax rate is 40%. Percy's CFO estimates
that the company's WACC is 9.96%. What is Percy's cost of common equity?

40% Debt; 60% Common equity; rd = 9%; T = 40%; WACC = 9.96%; rs = ?
WACC = (wd)(rd)(1 T) + (wc)(rs)
0.0996 = (0.4)(0.09)(1 0.4) + (0.6)rs
0.0996 = 0.0216 + 0.6rs
0.078 = 0.6rs
rs = 13%.

11-4
COST OF EQUITY WITH OR WITHOUT FLOTATION Javits & Sons common stock
currently trades at $30 a share. It is expected to pay an annual dividend of $3.00 a
share at the end of the year (D1= $3.00) and the constant growth rate is 5% a year.

A) what is the company's cost of common equity if all of its equity comes from retained
earnings?

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= 0.15= 15%


B) If the company were to issue new stock, it would incur a 10% otation cost. What
would the cost of equity from new stock be?

Floatation Costs = $30 10% = $3

= 0.1611= 16.11%


11-5
PROJECT SELECTION Midwest Water Works estimates that its WACC is 10.5%. The
company is considering the following capital budgeting projects:

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Assume that each of these projects is just as risky as the rm's existing assets and that
the rm may accept all the projects or only some of them. Which set of projects should
be accepted? Explain.


1. Capital Budgeting criteria; mutually exclusive projects. A rm with a WACC
of 10 percent is considering the following mutually exclusive projects
Project A
0 1 2 3 4 5
-400 $55 $55 $55 $225 $225
Project B
-600 $300 $300 $50 $50 $49




11-6
COST OF COMMON EQUITY The earnings, dividends, and common stock price of
Carpetto Technologies Inc. are expected to grow at 7 percent per year in the future.
Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will
pay a dividend of $2.14 at the end of the current year.
THIS IS A FOUR PART QUESTION, NOT MULTIPLE CHOICE.
(a) Using the DCF approach, what is the cost of common equity?
Cost of common equity Ke = D1/P0 +g
D1 = 2.00 (1 + 0.07) = 2.14
Ke = 2.14/23 + 0.07
= 16.30%

(b) If the rm's beta is 1.6, the risk-free rate is 9 percent, and the average return
on the market is 13 percent, what will be the rm's cost of common equity using
the CAPM approach?
Required rate of return = Risk free rate + beta x Market risk premium
= 9% + 1.6 (13% - 9%)
= 15.4%

(c) If the rm's bonds earn a return of 12 percent, what will rs be based on the
bond-yield-plus-risk-premium approach, using the midpoint of the risk premium
range?
Rs= Bond yield + Risk premium
=12%+4%
=16%
(d) Assuming you have equal con dence in the inputs used for the three
approaches, what is your estimate of Carpetto's cost of common equity?

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It is di cult to estimate beta and also growth rate has to be assumed to be constant.
Thus bond-yield plus risk premium approach is appropriate to calculate cost of equity.
Cost of common equity Ke = D1/P0 +g
=(2.14)/23+7%
=16.3%

11-7
The Evanec Company's next expected dividend, D1, is $3.18; its growth rate is 6%,
and its common stock now sells for $36.00. New stock (external equity) can be sold to
net $32.40 per share.
a) What is Evanec's cost of retained earning, rs ?
b) What is Evanec's percentage otation cost, F ?
c) What is Evanec's cost of new common stock, re ?

a). cost of retained earning (r)=D1/P0 +g r=3.18/36 + .06 r= .148 or 14.8%
b). Cost of oatation (F)=? P0=D1/r-g P0= 3.18/.158-.06 P0 = $32.45
c). Net Cost of new stock =$32
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11-8
COST OF COMMON EQUITY AND WACC Patton Paints Corporation has a target
capital structure of 40 percent debt and 60 percent common equity. The company's
before-tax cost of debt is 12 percent and its marginal tax rate is 40 percent. The
current stock price is Po= $22.50; the last dividend was Do=$2.00; and the dividend is
expected to grow at a constant rate of 7 percent. What will be the rm's cost of
common equity and its WACC?

Cost of Common Equity: 16.51
% WACC: 12.78%
Debt = 40%, Common equity = 60%.
P0 = $22.50,
D0 = $2.00,
D1 = $2.00(1.07) = $2.14, g = 7%.
rs = D1 / P0 + g = $2.14 / $22.50 + 7% = 16.51%.

WACC = (0.4)(0.12)(1 0.4) + (0.6)(0.1651)
WACC = 0.0288 + 0.0991 = 12.79%.

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11-14
COST OF PREFERRED STOCK INCLUDING FLOTATION Trivoli Industries plans to
issue some $100 par preferred stock with an 11% dividend. The stock is selling on the
market for $97.00: but otation costs will be 5% of the market price, so the net price
will be $92.15 per share. What is the cost of the preferred stock, including glotation?

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11-16
COST OF COMMON EQUITY The Bouchard Companys EPS was $6.50 in 2008, up
from$4.42 in 2003. The company pays out 40% of its earnings as dividends, and its
common stock sells for $36.00.
a.Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.)
b.The last dividend was D0y0.4($6.50)y$2.60. Calculate the next expected dividend,D1,
assuming that the past growth rate continues.
c.What is Bouchards cost of retained earnings, rs?

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