10-1 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?

Cost of Debt = Yield to Maturity x (1 - tax rate)
Cost of Debt = 12% x (1 - 0.35)
Cost of Debt = 7.80%

10-2 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%

10-3 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?

WACC = [Cost of Debt x Weight x (100% - tax rate)] + Cost of Equity x Weight.
9.96% = [9% x 40% x (100% - 40%)] + Cost of Equity x 60%
9.96% = 2.16% + Cost of Equity x 60%
9.96% - 2.16% = Cost of Equity x 60%
Cost of Common Equity = 7.8% / 60%
Cost of Common Equity = 13.00%

10-4 COST OF EQUITY WITH AND WITHOUT FLOTATION Javits & Sons’ common stock currently

trades at $30.00 a share. It is expected to pay an annual dividend of $3.00 a share at the

end of the year (D1 ¼ $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?

D1
Re  g
P0
 $3.0
Re   0.05
$30

= 0.15

= 15%

b. If the company issued new stock, it would incur a 10% flotation cost. What would be the cost of
equity from new stock?

Floatation Costs = $30 × 10% = $3

D1
Re  g
P0 Floatation Costs

$3
Re   0.05
$30-$3

= 0.1611

= 16.11%

10-5 PROJECT SELECTION Midwest Water Works estimates that its WACC is 10.5%. The

company is considering the following capital budgeting projects:

Project Size Rate of Return

A $1 million 12.0%

B 2 million 11.5

C 2 million 11.2
D 2 million 11.0

E 1 million 10.7

F 1 million 10.3

G 1 million 10.2

Assume that each of these projects is just as risky as the firm’s existing assets and that the

firm may accept all the projects or only some of them. Which set of projects should be

accepted? Explain.

The Midwest Water Works should accept those projects which have Rate of Return greater
than WACC (10.5%) because only the project whose return is greater than WACC will have a
positive NPV and would increase the value of the firm.

So Midwest Water Works should accept project A, B, C, D and E.

10-6 COST OF COMMON EQUITY The future earnings, dividends, and common stock price of

Carpetto Technologies Inc. are expected to grow 7% per year. Carpetto’s common stock

currently sells for $23.00 per share; its last dividend was $2.00; and it will pay a $2.14

dividend at the end of the current year.

a. Using the DCF approach, what is its cost of common equity?

D1
Re  g
P0

$2.14
Cost of Common Equity =  0.07
$23

= 16.3%

b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the average return on the market is

13%, what will be the firm’s cost of common equity using the CAPM approach?
Cost of Common Stock Equity = R f   (R m  R f )

= 9 + 1.6(13-9)

= 15.4%

c. If the firm’s bonds earn a return of 12%, based on the bond-yield-plus-risk-premium

approach, what will be rs? Use the midpoint of the risk premium range discussed in

Section 10-5 in your calculations.

The suggested appropriate risk premium range is from 3% to 5%. The mid-point of this range would,
therefore, be a risk premium (RP) of 4%
Rs= Bond yield + Risk premium
=12%+(Rm-Rf)
=12%+4%
16%

d. If you have equal confidence in the inputs used for the three approaches, what is your

estimate of Carpetto’s cost of common equity?

Equal confidence implies equal weighting being given to each of the estimates, and an overall
estimate of the firm’s cost of common equity can be calculated as an average across the estimates:
Cost of common equity (r S ) = (0.1630 + 0.1540 + 0.1600) / 3 = 0.1590 (15.90%)