Chapter 8: Cost of capital

1. Red Ball Inc. is expected to pay a $3.5 dividend at the end of the first year (D1), the
dividend is expected to grow at a constant rate of 6.5% a year, and the common stock
currently sells for $52.5 a share. The before-tax cost of debt is 8.5%, and the tax rate is 25%.
The target capital structure consists of 40% debt and 60% common equity.
a. What is the company’s WACC?
b. Is WACC increase or decrease if the firm’s debt-equity ratio is 0.75

2. Company B has a weighted average cost of capital of 7.5 %. The company's cost of equity
is 13.5 %, and its pretax cost of debt is 7.5 %. The tax rate is 30 %.
a. What is the company’s debt-equity ratio?
b. Will WACC increase or decrease if the debt-equity ratio is equal to 1?

3. A firm has 40,000 shares of common stock outstanding at a market price of $18.50 a
share. The firm also has a bond issue outstanding with a total face value of $260,000, which
is selling for 80% of par. The cost of equity is 14% while the after-tax cost of debt is 4.9%.
The firm pays a tax rate of 25%. What is the weighted average cost of capital?

4. ABC Corp. has 850,000 shares of common stock outstanding at a market price of $38 a
share. The cost of equity is 12.3%. The company also has 35,000 bonds outstanding that are
quoted at 103% of $1000 face value. The pre-tax cost of debt is 5.6%. The company’s tax
rate is 25%.
a. What weight should be given to the debt when the firm computes its weighted average
cost of capital?
b. What is the firm’s weighted average cost of capital (WACC)?

5. BWC maintains a debt-equity ratio of 0.65 and has a tax rate of 28%. The pre-tax cost of
debt is 8.8%. The company’s beta is 1.2. The current market risk premium is 6.5% and the
current risk-free rate is 2.6%. What is the weighted average cost of capital?

6. Suppose LD, Ltd., just issued a dividend of $2.62 per share on its common stock. The
company paid dividends of $1.51, $1.66, and $1.84 per share in the last 3 years.
a. What is the average growth rate over 3 years?
b. Given the growth rate in (a), calculate cost of equity.