Download 1. You were hired as a consultant to Keys Company, and you were

1. You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital
structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred
is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm’s
WACC?
a.
7.55%
b.
7.73%
c.
7.94%
d.
8.10%
e.
8.32%
Weighted cost of
Source of capital
Cost of capital
Weight
capital
Debt
4%
40%
1.600%
Preferred capital
7.50%
10%
0.750%
Common Stock
11.50%
50%
5.750%
Weighted average cost of capital (WACC) =
8.100%
2. Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an
8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company’s tax rate is 40%.
What is the component cost of debt for use in the WACC calculation?
a.
5.40%
b.
5.73%
c.
5.98%
d.
6.09%
e.
6.24%
Par value =
1,000
Coupon interest (8%/4)
20
PV =
-900.9
No. of years =
100
Cost of debt
2.25%
Cost of debt per annum
9%
After tax cost of debt =
5.4%
3. Tapley Inc. recently hired you as a consultant to estimate the company’s WACC. You have obtained the following
information. (1) Tapley's bonds mature in 25 years, have a 7.5% annual coupon, a par value of $1,000, and a market
price of $936.49. (2) The company’s tax rate is 40%. (3) The risk-free rate is 6.0%, the market risk premium is 5.0%, and
the stock’s beta is 1.5. (4) The target capital structure consists of 30% debt and 70% equity. Tapley uses the CAPM to
estimate the cost of equity, and it does not expect to have to issue any new common stock. What is its WACC?
a.
9.89%
b.
10.01%
c.
10.35%
d.
10.64%
e.
10.91%
Use financial calculator for solution
Par value =
1,000
Coupon interest (8%/4)
75
PV =
-936.49
No. of years =
25
Cost of debt
8.1%
After tax cost of debt =
4.86%
Cost of common stock = r RF + (r M – r RF) b
= 6% + (5%) 1.5
= 13.5%
WACC = 4.86% x 30% + 13.5% x 70%
= 10.91%
4. Wagner Inc estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC
of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the
company accept?
a.
Project A is of average risk and has a return of 9%.
b.
Project B is of below-average risk and has a return of 8.5%.
c.
Project C is of above-average risk and has a return of 11%.
d.
None of the projects should be accepted.
e.
All of the projects should be accepted.
Project B is of below-average risk and has a return of 8.5%.
Project B is of below average risk and so the rate to use is 8%. Since the project has a rate higher than 8%, it should
be selected.
5. The Nunnally Company has equal amounts of low-risk, average-risk, and high-risk projects. Nunnally estimates that
its overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but
that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. However, the CEO
argues that, even though the company’s projects have different risks, the WACC used to evaluate each project should be
the same because the company obtains capital for all projects from the same sources. If the CEO’s opinion is followed,
what is likely to happen over time?
a.
The company will take on too many low-risk projects and reject too many high-risk projects.
b.
The company will take on too many high-risk projects and reject too many low-risk projects.
c.
Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.
d.
The company’s overall WACC should decrease over time because its stock price should be increasing.
e.
The CEO’s recommendation would maximize the firm’s intrinsic value.
The company will take on too many high-risk projects and reject too many low-risk projects.
Since the company will use the same rate for all projects, this would mean that high risk projects which should be
evaluated using a higher rate are evaluated at the lower average rate and are selected while low risk projects which
should be evaluated using a lower rate are evaluated using a higher average rate and are rejected.
6. Percy Motors has a target capital structure of 40 percent debt and 60 percent common equity, with no preferred
stock. The yield to maturity on the company's outstanding bonds is 9 percent, and its tax rate is 40 percent. Percy's CFO
estimates that the company's WACC is 9.96 percent. What is Percy's cost of common equity? (FILL IN THE BLANK)
9.96% = 0.4 x Re + 0.60 x 9% (1 – 0.40)
Re = 16.8%
7. The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per
year in the future. Carpetto's common stock sells for $23 per share, its last dividend was $2.00, and it will pay a dividend
of $2.14 at the end of the current year. THIS IS A FOUR PART QUESTION, NOT MULTIPLE CHOICE.
(a) Using the DCF approach, what is the cost of common equity? (FILL IN THE BLANK)
Cost of common equity Ke = D1/P0 +g
D1 = 2.00 (1 + 0.07) = 2.14
Ke = 2.14/23 + 0.07
= 16.30%
(b) If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what will
be the firm's cost of common equity using the CAPM approach? (FILL IN THE BLANK)
Required rate of return = Risk free rate + beta x Market risk premium
= 9% + 1.6 (13% - 9%)
= 15.4%
(c) If the firm's bonds earn a return of 12 percent, what will rs be based on the bond-yield-plus-risk-premium approach,
using the midpoint of the risk premium range? (FILL IN THE BLANK)
Rs= Bond yield + Risk premium
=12%+4%
=16%
(d) Assuming you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's
cost of common equity? (FILL IN THE BLANK)
It is difficult to estimate beta and also growth rate has to be assumed to be constant. Thus bond-yield plus risk premium
approach is appropriate to calculate cost of equity.
Cost of common equity Ke = D1/P0 +g
=(2.14)/23+7%
=16.3%
QUESTION 7, PART B, C AND D ARE THE SAME AS QUESTIONS 8, 9, AND 10, RESPECTIVELY.