University of Tunis

Tunis Business School

Corporate Finance
Tutorial n°3: The Cost Of Capital
Professor: Dr. Ridha ESGHAIER

(Fall 2021)

Multiple Choice Questions

Q1. Which one of the following represents the best estimate for a firm's pre-tax cost of debt?
a. the current coupon on the firm's existing debt
b. the firm's historical cost of capital
c. twice the rate of return currently offered on risk-free securities
d. the original yield to maturity on the latest bonds issued by a firm
e. the current yield to maturity of the firm's outstanding bonds.
Q2. A firm's overall cost of capital:
a. varies inversely with its cost of debt
b. is unaffected by changes in the tax rate
c. is another term for the firm’s expected growth rate
d. is the same as the firm’s return on equity
e. is the required return on the total assets of a firm.
Q3. An increase in the market value of a preferred stock will _____ the cost of preferred stock.
a. increase
b. not affect
c. either increase or decrease
d. either not affect or increase
e. decrease.

Q4. If pertinent information concerning the target weights is missing, capital structure weights are based on the:
a. firm's dividend and bond yields
b. market value of a firm's equity and the face value of its debt
c. initial issue values of a firm's debt and equity
d. book value of a firm's debt and equity
e. The market values of a firm's debt and equity.

Q5. All of the following statements about the WACC are true EXCEPT:
a. WACC is the rate of return a firm must earn on its existing assets to maintain the current value of its stock.
b. WACC is the minimum acceptable return on any current average risk project under consideration today
c. WACC is commonly used in discounting or capitalizing returns to common equity holders.
d. WACC is the return earned and paid on a company's securities in the past.
e. WACC is especially appropriate for any project selection in capital budgeting.

Q6. Which one of the following is a correct statement regarding a firm's weighted average cost of capital (WACC)?
a. An increase in the market risk premium will tend to decrease a firm's WACC
b. A reduction in the risk level of a firm will tend to increase the firm's WACC
c. A 5 percent increase in a firm's debt-equity ratio will tend to increase the firm's WACC
d. The WACC depends upon how the funds raised are going to be spent.
e. The WACC will decrease when the tax rate decreases for all firms that utilize debt financing

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Exercise 1: market value, book value, target capital structure and WACC
A company’s balance sheets show a total of $25 million long-term debt with a coupon rate of 10%. The yield to
maturity on this debt is 11%, and the debt has a total current market value of $20 million. The balance sheets also
show that the company has 10 million shares of stock; the total of common stock and retained earnings is $25
million. The current stock price is $8 per share. The current return required by stockholders, rS, is 12%. The
company has a target capital structure of 40% debt and 60 % equity. The tax rate is 40%.
What weighted average cost of capital should you use to evaluate potential projects?

Exercise 2: WACC and debt-equity ratio

Company ABC desires a weighted average cost of capital of 8%. The firm has an aftertax cost of debt of 4.8% and
a cost of equity of 15.2%. What debt-equity ratio is needed for the firm to achieve its targeted weighted average
cost of capital?

Exercise 3: Capital structure Weights

A corporation has 125,000 shares of common stock with a required return of 9% and last dividend payment of 1.8$
per share that expected to grow at a constant rate of 4%. They also have 25,000 shares of preferred stock
outstanding which pay annual dividend of 2$ per share and have a total return of 5%. There are 10,000, 9% bonds
outstanding that mature in 16 years and pay interest semiannually, the required return for that type of bond is 10%.
What is the weight for each capital structure component?
If the tax rate is 40%, what is the corporation’s WACC?

Exercise 4: Cost of Equity

The earnings, dividends, and stock price of a firm are expected to grow at 7% per year in the future. Its common
stock sells for $23 per share and its last dividend was $2.00.
a. Using the discounted cash flow approach, what is its cost of the company’s retained earnings?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is 13%, then what would
be the required return on the firm’s retained earnings based on the CAPM approach?
c. If the firm’s bonds earn a return of 12%, then what would be your estimate of the required return on the firm’s
retained earnings using the over-own-bond-yield-plus-judgmental-risk-premium approach?
(Hint: Use the midpoint of the risk premium range)
d. On the basis of the results of parts a through c, what would be your estimate of the firm’s cost of retained
earnings?

Exercise 5: Cost of Equity

A company’s current EPS is $6.50. It was $4.42 five years ago. It pays out 40% of its earnings as dividends, and
the stock sells for $36.
a. Calculate the historical growth rate in earnings. (Hint: This is a 5-year growth period.)
b. Calculate the next expected dividend per share, D1. Assume that the past growth rate will continue.
c. What is its cost of equity, rs?

Exercise 6: WACC
A firm has the following capital structure, which it considers to be optimal: debt = 25%, preferred stock = 15%, and
common equity = 60%. Its tax rate is 40%, and investors expect earnings and dividends to grow at a constant rate
of 6% in the future. The firm paid a dividend of $3.70 per share last year (D0), and its stock currently sells at a price
of $60 per share.
Ten-year Treasury bonds yield 6%, the market risk premium is 5%, and the firm’s beta is 1.3. The following terms
would apply to new security offerings.
- Debt: new annual bonds will be issued at par ($100) with flotation costs of 4%. Their maturity is 10 years
and coupon rate of 8%.
- Preferred: New preferred could be sold to the public at a price of $100 per share, with a dividend of $9.
Flotation costs of $5 per share would be incurred.
- Common: New common equity will be raised only by retaining earnings.

a. Find the component costs of debt, preferred stock, and common equity.
b. What is the WACC?

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Exercise 7: WACC market value weights
The following are known about a public Company:
- 4 million shares of common stock issued and outstanding
- Closing common stock price per share: $10
- 2 million shares of preferred stock issued and outstanding
- Closing preferred stock price per share: $16
- $10 million face value of bonds issued and outstanding
- Closing bond price: 80 (80% of face value)
- Cost of common equity for the company: 25%
- Cumulative, nonparticipating dividend on the preferred stock: $2.40 per share every year
- Cost of debt before tax effect: 10%
- Combined federal and state income tax rate: 40%

a. What is the cost of preferred equity for the Company?

b. What is its after-tax cost of debt?
c. Compute the market value of invested capital (MVIC) and the weights for each capital structure
component for the Company.
d. Compute its WACC

Exercise 8: cost components calculation

A Corporation has 14 million shares of common stock outstanding, 900,000 shares of 9% preferred stock
outstanding and 210,000, 10% semiannual bonds outstanding, par value $1,000 each. The common stock
currently sells for $34 per share and has a beta of 1.15, the preferred stock currently sells for $80 per share,
and the bonds have 17 years to maturity and sell for 91% of par. The market risk premium is 11.5%, T-bills
are yielding 7.5%, and the firm's tax rate is 32%. What discount rate should the firm apply to a new project's
cash flows if the project has the same risk as the firm's typical project?

Exercise 9: WACC

On January 1, the total market value of a company was $60 million. During the year, the company plans to raise
and invest $30 million in new projects. The firm’s present market value capital structure, shown below, is
considered to be optimal. There is no short-term debt.
Debt $30,000,000
Common equity 30,000,000
Total capital $60,000,000

New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a
share. The stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and
an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30
= 4%.) The marginal tax rate is 40%.

a. In order to maintain the present capital structure, how much of the new investment must be financed by
common equity?
b. Assuming there is sufficient cash flow for the company to maintain its target capital structure without issuing
additional shares of equity, what is its WACC?
c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock.
Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.

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