Instructions:
You are required to use a financial calculator or spreadsheet (Excel) to solve 10 problems (provided on page 3) related to the cost of capital. You are required to show the following 3 steps for each problem (sample questions and solutions are provided for guidance):
(i) Describe and interpret the assumptions related to the problem.
(ii) Apply the appropriate mathematical model to solve the problem.
(iii) Calculate the correct solution to the problem.
Sample Questions and Solutions
Sample Question:
A company is expected to pay a $3.50 dividend at year-end, the dividends are expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?
Solution
(i) The problem assumes the stock will have a constant growth of 6.5% forever. The constant growth model is appropriate to use for this problem. The accuracy of the solution depends on the correctness of the constant growth assumption.
The cost of equity assumes there will not be any new stock issuance. Therefore, the cost of equity is the cost of retained earnings for the existing shareholders.
The cost of debt should be on after-tax basis due to the tax shield provided by the interest expense.
(ii) The cost of equity is based on the following: Kre = (D1/P0) + g P0 is the current price to be calculated,
D1 is the next period’s dividend,
R is the required return on this stock
• g is the constant growth
The cost of debt is based on kd = rd(1-T)
rd is the before-tax cost of debt
T is the tax rate
The WACC is based on: WACC = wdkd + wrekre
(iii) Cost of retained earnings = (3.5/62.5) + 0.065 = 0.121 or 12.1% Cost of debt = 7.5 x (1-0.4) = 4.5%
WACC = (0.4x4.5) + (0.6x12.1) = 9.06%
The average cost of capital for this company based on their existing debt and equity is 9.06%
Question that need to be answer are:
1. ABC Corp. is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be $50 per bond. The marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?
2. New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60 every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be 4%. If the firm has a 35% marginal tax bracket, what is cost of existing debt?
Please if you answer correctly with the explanation.