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Kuwait University
College of Business Administration
Department of Finance & Financial Institutions
Capital Budgeting and Long-term Financing
2nd Mid-term’s Exam
Spring 2005-2006
Model Answer
2nd Mid-term Exam
SOA Inc., current capital structure consists of $10,000,000 in long-term loan,
20,000 bonds, 100,000 preferred stocks, $30,000,000 in common stocks, and
$10,000,000 in retained earnings.
1. The bank charges SOA Inc. a risk premium of 3% above the risk free rate.
The real interest rate (R*) in the economy is 4% and inflation is expected
to be 5% over the next few years (Rf = R* + Inf.).
2. The SOA Inc.'s 10-years bonds are issued at 12% semiannual coupon,
have a current time to maturity of 4 years, sells for $923, and interest rate
on comparable bonds is 14%.
3. The Inc.'s preferred stocks have face value of $100, pay 11% annual
dividends, and have a market value of $92 per share.
4. SOA Inc. is constant growth firm which just paid dividends of $2.00, has a
growth rate of 4%, and its common stocks are traded for $25.00 per share.
5. SOA Inc. is subject to 40% corporate tax.
Given that:
SOA Inc. has a new project for $20,000,000 that can be financed through
bank's loans or common stocks.
A. If the project financed through the bank loans, the bank will charge
the SOA Inc. the same interest rate charge for the old loan, but the
interest will be paid at the beginning of the year.
B. The bank's loan will increase the company risk, therefore the
common shareholders are expected to ask for 1% increase in the
required rate of return (cost of common stocks will increase by 1%).
C. If the project financed through issuing common stocks, nothing will
change in the company's cost structure.
D. SOA Inc. has 40% probability to finance the new project through
bank loan and 60% probability to finance the project through
issuing common stocks.
Kindly:
1. Calculate the WACC under each scenario.
2. Calculate the Expected WACC.
3. Calculate the Standard Deviation of the WACC.
GOOOOOOOOOOOOD LUCK
1
2nd Mid-term Exam
Model Answer
Capital
Structure
Bank Loans
Old
New
10,000,000
20,000,000
10%
20%
7.20% 0.7200% 10,000,000
8.18% 1.6360%
10%
7.20% 0.7200%
Bonds
20,000,000
20%
9.08% 1.8160% 20,000,000
20%
9.08% 1.8160%
Preferred Stocks
10,000,000
10%
11.96% 1.1960% 10,000,000
10%
11.96% 1.1960%
Common Stocks
Old
New
30,000,000
30%
13.32% 3.9960% 30,000,000
20,000,000
30%
20%
12.32% 3.6960%
12.32% 2.4640%
Retained Earnings
Total Cap
10,000,000 10% 12.32% 1.2320% 10,000,000 10% 12.32% 1.2320%
100,000,000 100%
10.596% 100,000,000 100%
11.124%
$ Cap
Scenario # 1
Weight Cost
WACC
$ Cap
Scenario # 2
Weight Cost
WACC
Notice:
1. Cost of Old Loan = 4%+5%+3%= 12% * (1-40%) = 7.2%
2. Cost of New Loan =
12%
(1  40%)  8.1818%  8.18%
1  12%
3. Cost of Bonds = YTM * (1-40%) = 15.13% * 60% = 9.08%
Given That
PV = -$923, PMT=Coupon = 1,000 * (12%/2) = $60, N = 4 * 2 = 8, FV = $1,000
Then YTM = 7.3% Semiannual = Annual YTM = (1+ 7.3%)2 – 1 = 15.13%
4. Cost of Preferred Stocks =
11
 11.96%
92
5. Cost of Common Stocks = Cost of Retained Earnings =
2 * (1  4%)
 4%  12.32%
25
Cost of Common Stocks Under First Scenario = 12.32%+1% 13.32%
Expected WACC = (10.596% * 40%) + (11.124 * 60%) = 10.9128% ≈ 10.91%

W ACC

(10.91%10.596%) * 40%  (10.91%11.124%)* * 60%  0.26%
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