Cost of capital
1
Self-Test Problem
(ST-1)
WACC
Longstreet Communications Inc. (LCI) has the following capital structure, which it considers to be
optimal:
debt = 25%,
preferred stock = 15%,
and common stock = 60%.
LCI’s tax rate is 40% and investors expect earnings
and dividends to grow at a constant rate of 6% in the future.
LCI paid a dividend of $3.70 per share last year (D ),0
and its stock currently sells at a price of $60 per share.
Treasury bonds yield 6%,
the market risk premium is 5%,
and LCI’s beta is 1.3. These terms would apply to new security offerings:
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.
Debt:
Debt could be sold at an interest rate of 9%.
a. Find the component costs of debt, preferred stock, and common stock.
Assume LCI does not have to issue any additional shares of common stock.
b. What is the WACC?
10-10
2
Cost of Equity
The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year
in the future.
Shelby’s common stock sells for $23 per share,
its last dividend was $2.00,
and the company will pay a dividend of $2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of equity?
b. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on the market is
13%, what will be the firm’s cost of equity using the CAPM approach?
c. If the firm’s bonds earn a return of 12%, what will rs be using the bond-yieldplus-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 you estimate Shelby’s cost of
equity to be?
10-15
3
WACC Estimation
On January 1, the total market value of the Tysseland 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.
Assume that 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.
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
$1.20/$30 _ 4%.)
The marginal corporate tax rate is 40%.
a. To maintain the present capital structure, how much of the new investment must be financed
by common equity?
b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital
structure without issuing additional shares of equity. What is the 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?
4
(10-11)
Cost of Equity
Radon Homes’ current EPS is $6.50.
It was $4.42 5 years ago.
The company pays out 40% of its earnings as dividends,
and the stock sells for $36.
a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.)
a. 8%.
b. Calculate the next expected dividend per share, D1 [D0 _ 0.4($6.50) _ $2.60].Assume that the
past growth rate will continue
b. $2.81.
c. What is the cost of equity, rs, for Radon Homes?
c. 15.81%.
(10-12)
Calculation of
g and EPS
Spencer Supplies’ stock is currently selling for $60 a share.
The firm is expected to earn $5.40 per share this year
and to pay a year-end dividend of $3.60.
a. If investors require a 9% return, what rate of growth must be expected for Spencer?
a. g = 3%.
b. b. If Spencer reinvests earnings in projects with average returns equal to the stock’s
expected rate of return, what will be next year’s EPS? [Hint: g _ ROE(Retention ratio).]
b. EPS1 = $5.562.
(10-13)
The Cost of Equity
and Flotation Costs
Messman Manufacturing will issue common stock to the public for $30.
The expected dividend and growth in dividends are $3.00 per share
and 5%, respectively.
If the flotation cost is 10% of the issue proceeds,
what is the cost of external equity, re?
16.1%.
(10-14)
The Cost of Debt
and Flotation Costs
Suppose a company will issue new 20-year debt
with a par value of $1,000
and a coupon rate of 9%, paid annually.
The tax rate is 40%.
If the flotation cost is 2% of the issue proceeds,
what is the after-tax cost of debt?
(1 _ T)rd = 5.57%.
(10-16)
5
Market Value Capital
Structure
Suppose the Schoof Company has this book value balance sheet:
Current assets $30,000,000
Current liabilities $10,000,000
Fixed assets 50,000,000
Long-term debt 30,000,000
Common equity
Common stock
(1 million shares) 1,000,000
Retained earnings 39,000,000
Total assets $80,000,000
Total claims $80,000,000
The current liabilities consist entirely of notes payable to banks,
and the interest rate on this debt is 10%, the same as the rate on new bank loans.
The long-term debt consists of 30,000 bonds,
each of which has a par value of $1,000,
carries an annual coupon interest rate of 6%,
and matures in 20 years.
The going rate of interest on new long-term debt,
rd, is 10%, and this is the present yield to maturity on the bonds.
The common stock sells at a price of $60 per share.
Calculate the firm’s market value capital structure.
Short-term debt = 11.14%;
Long-term debt = 22.03%;
Common equity = 66.83%.
