Financial Management

Problem Set - Chapter 4

Cost of Capital

HOMEWORK

1. The company NEW is about to be listed in the stock market. The target capital structure of
this company is to have the same amount of Debt and Equity (i.e. D/E = 1 or D/V=50%), in
market value terms. The beta debt of company NEW is estimated to be 0.20. We know that
the operations of the company have the same risk that the average of the sector and that
the corporate tax rate is 35%. Using the data in the following table, which refers to other
firms in the same sector, compute the beta equity for company NEW after its listing in the
stock exchange. Hint: use the average of the betas of the three companies and be careful to
distinguish asset betas from equity betas.

Company 1 Company 2 Company 3

Millions of shares 150 95 220
Price per share 10.00€ 20.00€ 4.00€
Market value of debt (M€) 500€ 700€ 500€
Beta debt 0.15 0.20 0.15
Beta equity 1.20 1.00 1.40

2. The company SOFT develops software for applications and is working in developing a new
software application that is similar to the ones developed in the past by the company. Initially
without debt, the company decides to issue debt with the objective of financing this new
project that will generate a return equal to the cost of capital. SOFT is listed in the stock
Exchange and its market capitalization before the issuance was 57.6M$ and its beta equity
was 1.2. SOFT wants to issue perpetual debt, it has a nominal value of 27M$, offers a coupon
of 2% and its bond-rating is translated into a Spread of 3%. At the time of the issue, the
interest on long term government bond in the US was 6%, the market risk Premium was 6%,
and the corporate tax rate was 40%.
a) Find out the new leverage of the company after issuing its debt (D/E).
b) Determine beta debt.
c) Determine the change in the required return on equity due to the debt issue.
d) Determine the WACC of SOFT after the issue.

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3. Consider the following table with market values and capital structure of company ERT.
Market value %
Common shares 90,000,000€ 45.0%
Preferred shares 50,000,000€ 25.0%
Long term debt 60,000,000€ 30.0%
Total 200,000,000€ 100.0%
The current financing of the company has the following characteristics:
The nominal value of debt, which is perpetual, is 55,000,000€ and the annual coupon rate is
7%. Preferred shares enjoyed a dividend in the last year of 5,000,000€ and dividends present
a growth rate of 1%. The levered beta equity of common shares is 1.4. The risk free rate is
4%, the historical market risk Premium is 7% and the corporate tax rate is 25%.
Determine the WACC of this company.