Question 15.

1
Suppose the stock in Watta Corporation has a beta of 0.8. The market risk premium is 6 percent, and the risk-free rate
is 6 percent. Watta’s dividend will be $1.20 per share next year and the dividend is expected to grow at 8 percent
indefinitely. The stock currently sells for $45 per share. What is Watta’s cost of equity capital?
Solution:
Using SML, the expected return on Watta's common stock is:
RE = Rf + ßE x (RM - Rf)
= 6% + .80 x 6%
= 10.80%
Using Dividend growth model, The projected dividend is DO x (1 + g)
= $1.20 x 1.08 = $ 1.296, so the expected return using this approach is
RE = D1/PO + g
= $1.296/45 + .08
= 10.88%
Because these two estimates, 10.80 percent and 10.88 percent, are fairly close, we will average them. Watta's cost of
equity is approximately 10.84 percent.

Question 15.2
In addition to the information given in the previous problem, suppose Watta has a target debt-equity ratio of 50%. Its
cost of debt is 9 percent before taxes. If the tax rate is 35 percent, what is the WACC?
Solution:
Because the target debt-equity ratio is .50, Watta uses $.50 in debt for every $1 in equity. In other words, Watta's
target cpital structure is 1/3 debt and 2/3 equity . The WACCA is thus:
WACC = (E/V) x RE + (D/V) x (1 - TC)
= 2/3 x 10.84% + 1/3 x 9% x (1 - .35)
= 9.177%

Question 15.3
Suppose in the previous problem Watta is seeking $30 millionfor a new project. The necessary funds will have to be
raised externally. Watta’sflotation costs for selling debt and equity are 2 percent and 16 percent, respec-tively. If
flotation costs are considered, what is the true cost of the new project?
Solution:
Beacuse Watta uses both debt and equity to finance its operations, we first need the weighted average flotation cost.
As is the previous problem, the percentage of equity financing is 2/3, so the weighted average cost is:

fA = (E/V) X fE + (D/V) X fD
= 2/3 X 16% + 1/3 X 2%
= 11.33%
If Watta needs $30 million after flotation costs, then the true cost of the project is $30 million/(1 - f A) = $30
million/.8867 = $33.83 million

Question
Suppose we have a bond issue currently outstanding that has 20 years left to maturity. The coupen rate is 11% with
annual payments. The bond is currently selling for $950. If the pa value is $1000 per bond and the tax rate is 40%,
calculate the after-tax cost of debt.
Solution:
Cuopen Rate = 11%
Par Value = 1000
Annual Payments = 1,000 x 0.11 = 110
Market Value = 950
Number of years remaining till maturity = 20 years
Approximate YTM = (Annual Interest + Accrued Capital Gain) / Average Value Of Bond
= (11% X 1000 + (1000-950)/20) / ((2 x 950 + 1000)/3)
= 11.64%
After Tax Cost Of Debt = Cost(1-Tax) = 11.64(1-0.4) = 6.98%

Question:
Your company has an outstanding preferred equity that has an annual dividend of $10.5. If the preferred stock is
selling for $100, and each new share issued will carry a floatation cost of $4, calculate the cost of preferred equity?
Solution:
Annual Dividend = 10.5
Market Rate = 100
Flotation Cost = 4
Cost Of Preferred Equity = 10.5 / (100 - 4) = 10.94%

Question:
Suppose that your company is expected to pay a common dividend of $1.50 per share next year. There has been a
steady growth in dividends of 7% per year and the market expects that to continue. The current price is $30 and the
floatation cost if $3 per common share. What is the cost of common equity (retained earnings and new common
shares)?
Solution:
D1 = 1.5
g = 7%
Po = 30
F=3
Cost of common equity = D1/P0 + g = 1.5/(30-3) + 0.07 = 12.56%
Cost of internal sourcing = D1/P0 + g = 1.5/(30) + 0.07 = 12%