Strictly for course AB1201 internal circulation only.

Nanyang Business School

AB1201 Financial Management
Tutorial 7: The Cost of Capital
(Common Questions)
Questions 1 to 4 will be presented by students while Question 5 will be presented by instructors.

1) Cost of debt. To help finance a new playground facility, Millenium Company has a $1,000 par
value bond outstanding with 10 years to maturity. The bond carries an annual interest payment of
$66 and is currently selling for $925. If the firm's tax rate is 40%, what would the after-tax cost
of debt for use in the WACC calculation be?

2) Cost of common equity with flotation. Ballack Co.s common stock currently sells for $46.75
per share. The company has an expected dividend yield of 5%. The expected long-run dividend
payout ratio is 25%, and the expected return on equity (ROE) is 16%. New stock can be sold to
the public at the current price, but a flotation cost of 5% would be incurred. What would be the
cost of new equity? (Hint: g = Retention rate x ROE)

3) WACC AND Optimal Capital Budget. Adams Corporation is considering four average-risk
projects with the following costs and rates of return:

Project Cost Expected rate of return

1 $2000 16.00%
2 $3000 15.00
3 $5000 13.75
4 $2000 12.50

The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 30%. It can
issue preferred stock that pays a constant dividend of $5.00 per year at $49.00 per share. Also, its
common stock currently sells for $36.00 per share; the next expected dividend, D1, is $3.50; and
the dividend is expected to grow at a constant rate of 6% per year. The target capital structure
consists of 75% common stock, 15% debt, and 10% preferred stock.
a) What is Adams Corporation WACC?
b) Which projects should Adams Corporation accept?
c) Suppose Adams Corporation adjusts for risk by adding 2 percent to the WACC for high-risk
projects and subtracting 2 percent for low-risk projects. Suppose Project 2 is in fact a high risk
project and Project 4 is a low risk project. Which projects should Adams accept?

4) Two analysts of a company estimate/compute the WACC and get different values, what can be
the factors/reasons that cause these calculated WACCs to be different? Assume both analysts have
the same access to information about the company as stated in the annual reports.

5) Calculating the WACC. Here is the condensed 2012 balance sheet for Skye Computer
Company (in thousands of dollars):

2012
Current assets $2,000
Net fixed assets 3,000
Total assets $5,000

Current liabilities $900

Page 1 of 3
 Strictly for course AB1201 internal circulation only.

Long-term debt 1,200

Preferred stock (10,000 shares) 250
Common stock (50,000 shares) 1,300
Retained earnings 1,350
Total common equity $2,650
Total liabilities & equity $5,000

Skye's earnings per share last year were $3.20. The common stock sells for $55.00, last years
dividend (D0) was $2.10, and a flotation cost of 10% would be required to sell new common
stock. Security analysts are projecting that the common dividend will grow at an annual rate of
9%. Skye's preferred stock pays a dividend of $3.30 per share, and its preferred stock sells for
$30 per share. The firm can issue long-term debt at an interest rate (or before-tax cost) of 10%,
and its marginal tax rate is 35%. The firm's currently outstanding 10% annual coupon rate long-
term debt sells at par value. The market risk premium is 5%, the risk-free rate is 6%, and Skye's
beta is 1.516. In its cost of capital calculations, the company considers only long-term capital;
hence, it disregards current liabilities for calculating its WACC.

a) Calculate the cost of each capital component, that is, the after-tax cost of debt, the cost of
preferred stock, the cost of equity from retained earnings, and the cost of newly issued common
stock. Use the DCF method to find the cost of common equity.

b) Now calculate the cost of common equity from retained earnings using the CAPM method.

c) If Skye continues to use the same market-value capital structure, what is the firm's WACC
assuming that (1) it uses only retained earnings for equity? (2) If it expands so rapidly that it
must issue new common stock?
___________________________________________________________________________

Self-practice Questions

Question1:
Valcon's target capital structure is 35% debt, 15% preferred stock and 50% common stock.
Currently, its common stock is traded at a price of $10 per share. The company has just paid
dividends of $1.10 per share. The perpetual common dividend growth rate is constant at 5%. The
company's preferred stock is selling at $30 and its required rate of return is 6% in the current
market. Flotation costs have been estimated at 6% for common stock and 3% for preferred stock.
Valcon has bonds outstanding at 10% coupon rate, but interest rates for bonds of equal risk are
currently yielding 7% in the market. Valcon's tax rate is 30%.

What is Valcons weighted average cost of capital (WACC) if it has to issue new preferred stock
and new common stock?

Question 2
LeXings common shares are currently trading at $25 per share. The next common share dividend
is expected to be $1.80 per share. Annual dividend growth rate is expected to be constant at 5%
perpetually. Its outstanding annual-coupon bonds, with par value of $1,000 and coupon rate of 8%,
are currently traded at $970. The bonds still have 5 years to maturity. The company has no
preferred stock. LeXings target capital structure is 35% debt and 65% equity. What is LeXings
WACC? Assume tax rate of 30%.

Page 2 of 3
 Strictly for course AB1201 internal circulation only.

Answers to Self-practice Questions:

Question 1
Step 1: Find cost of debt:
rd = 7% (1 0.30) = 4.90%
Step 2: Find cost of preferred stock taking into account flotation cost
Flotation cost per preferred stock = 3% x $30 = $0.90
Dividend per preferred stock = 6% x $30 = $1.80
Therefore, rp = 1.80 / (30 0.90) = 6.186%
Step 3: Find cost of new equity:
D1 = $1.10 x 1.05 = $1.155
Floatation cost per common stock = 6% x $10 = $0.60
rs = 1.155/(10 0.60) + 5% = 17.287%
Step 4: Find WACC
WACC = 0.35x4.90% + 0.15x6.186% + 0.50x17.287% = 11.286%

Question 2
Cost of equity (rs) = D1/P0 + g = 1.80/25 + 5% = 12.2%

Cost of debt (rd):

970 = 80/(1+rd) + 80/(1+rd)2 + 80/(1+rd)3 + 80/(1+rd)4 + (80+1000)/(1+rd)5
rd = 8.7666%

WACC = 0.35(8.7666%)(1-30%) + 0.65(12.2%) = 10.08%

Page 3 of 3