Problem 11-1

Solution

Wacc = Debt x yield to maturity x (tax rate) + 60% x (the cost of equity capital)

9.96% = 40%*9%*60% + 60% x (the cost of equity capital)

(40%*9%*60% is the bonds, the 60% comes in because its tax deductible, tax rate is 40%, so after tax
cost is 60%)

So 0.0996 = 0.4*0.09*0.6 + 0.60 (the cost of equity capital)

0.0996 = 0.0216 + 0.60 (the cost of equity capital)

0.078 = 0.60 (the cost of equity capital)

The cost of equity capital = 0.078/0.60

The cost of equity capital = 0.13 or 13%

Problem 11-2

Solution

Cost of preferred stock = Annual dividend / net proceeds

Net proceeds = Market price – Floatation costs = $50 – (5% of $50) = $47.5

Cost of preferred stock = 3.80 / 47.5

Cost of preferred stock = 0.08

Problem 11-3

Solution

Re = (D1 / P0) + g

Where:

Re = Cost of Equity

D1 = Dividends/share next year

P0 = Current share price

g = Dividend growth rate

RE = (3 / 30) + 5%

RE = 0.1 + 0.05

RE = 15%

Problem 11-4

Solution

After tax cost of debt is "tax effected" = (1 - tax rate)

a. With 0% tax rate, after tax cost of debt is = (1 - 0) * 13% = 13%.

b. With 20% tax rate, after tax cost of debt is = (0.80*0.13) = 10.4%

c. With 35% tax rate, after tax cost of debt is = (0.65*0.13) = 8.45%
Problem 11-5

Solution

Cost of Debt = Yield to Maturity x (1 - tax rate)

Cost of Debt = 12% x (1 - 0.35)

Cost of Debt = 12% x (0.65)

Cost of Debt = 0.078

Cost of Debt =7.80%

Problem 11-6

Solution

Given

Dividend per share = 11 %( 100) = 11

Selling Price = 97

Floatation cost = 5%

Net price = 97 – (0.05 x 97) = 92.15

SO

Cost of preferred stock = dividend / net price

Cost of preferred stock = 11 / 92.15

Cost of preferred stock = 11.94%

Problem 11-8

Solution

 Using the DCF approach, what is the cost of equity?

Cost of common equity
Ke = D1/P0 +gD1
= 2.00 (1 + 0.07)
= 2.14
Ke = 2.14/23 + 0.07= 16.30%

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

 If the firm's bonds earn a return of 12 percent, what will Ks be using the bond-yield-plus-risk-
premium approach, use the midpoint of the risk premium range?
Rs = Bond yield + Risk premium
= 12% + 4%
= 16%

 On the basis of results of part a through c, what would you estimate of Carpetto's cost of
equity?
It is difficult 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 equity Ke = D1/P0 +g
= (2.14) / 23 + 7%
= 16.3%
Problem 11-9

Solution