Chapter 14

1. Cost of capital, cost of debt, and cost of equity.

Cost of Capital: The minimum rate of return or profit a
company must earn before generating value.

Cost of Debt: The effective interest rate that a company pays on

its debts, such as bonds and loans.

Cost Of Equity: The return that a company requires for an

investment or project, or the return that an individual requires
for an equity investment.

2. Suppose we have a bond issue currently outstanding that

has 25 years left to maturity. The coupon rate is 9%, and
coupons are paid semiannually. The bond is currently
selling for $908.72 per $1,000 bond. What is the cost of
debt?

N = 50
PMT = 45
FV = 1000
PV = -908.72
CPT I/Y = 5%
YTM = 5(2) = 10%
 3. Cost of preferred stock: The price it pays in return for the
income it gets from issuing and selling the stock. In other
words, it's the amount of money the company pays out in
a year divided by the lump sum they got from issuing the
stock.

4. Cost of equity: SML approach (CAMP), pros and cons

It helps to determine if the stock is overvalued or
undervalued. It helps to determine the risk and return
relationship of a security. Disadvantages of Security Market
Line: It is based on CAPM model which considers market
risk only.

5. Suppose your company has an equity beta of .58, and the

current risk-free rate is 6.1%. If the expected market risk
premium is 8.6%, what is your cost of equity capital?
Cost of Equity = Risk Free Rate + Beta (Market Risk
Premium)

Re = 6.1 + .58(8.6) = 11.1%

6. Cost of equity: dividend growth model approach, pros and

cons
Pro: Helps investors determine a fair price for a company's
shares, using the stock's current dividend, the expected future
growth rate of the dividend and the required rate of return for
the individual's portfolio
Con: The fact that it does not factor in buybacks, and its
fundamental assumption of income only from dividends.

7. Suppose that your company is expected to pay a dividend

of $1.50 per share next year. There has been a steady
growth in dividends of 5.1% per year and the market
expects that to continue. The current price is $25. What is
the cost of equity?

Re = 1.50 / 25 + .051 = .111 = 11.1%

8. Estimate dividend growth rate:

Year Dividend Percent Change
2008 1.23 ---------
2009 1.30 .94615
2010 1.36 .95588
2011 1.43 .95104
2012 1.50 .95333

9. WACC

Weighted average cost of capital (WACC) represents a firm's

average after-tax cost of capital from all sources, including
common stock, preferred stock, bonds, and other forms of debt.
WACC is the average rate that a company expects to pay to
finance its assets.

10. Example of WACC:

Equity information: 50 million shares, $80 per share, Beta
= 1.15, market risk premium = 9%, risk-free rate = 5%.
Debt information: $1 billion in outstanding debt (face
value), current quote = 110, coupon rate = 9%,
semiannual coupons, 15 years to maturity
Tax rate = 40%