Q.No.1 Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent.

t. What is its WACC?

Security Market value Required return
Debt 20,000,000 6%
Preferred stock 10,000,000 8%
Common stock 50,000,000 12%

Solution:

Security Market value Required return Investment Weightage WACC

Debt 20,000,000 6% 25.00% 0.98%
Preferred stock 10,000,000 8% 12.50% 1.00%
Common stock 50,000,000 12% 62.50% 7.50%
9.48%

Security Weight (W) Cost (k) WACC

Debt 0.25 6% (1-35%) 0.98%
Preferred stock 0.125 8% 1.00%
Common stock 0.625 12% 7.50%
9.48%
cent. What is its WACC?
Q.No.2 A company has issued 10 year bond a year ago at par value with a coupon rate of 9%, paid annually. Today the bon
selling at 1150. Firm is in the tax bracket of 40%. Company has preferred stock on which dividend is fixed $ 4 and
market price of preferred stock is $ 45. Company issued common stock, dividend currently paid $2 which is expect
to grow at a rate of 4% and stock is selling at $ 25. If company is planning to invest in a project at a ratio of 40:20:4
What should be weighted average cost of capital of this project?

Solution:

Bond n 9 years
CR 9%
Price 1150
Tax 40%
Prefered Stock
D 4
P0 45
Common Stock
D0 2
g 4%
P0 25
Investment Weightage
Debt 40%
Prefered 20%
Common 40%

Security Investment Required WACC

Weightage return
Debt 40% 6.72% 1.61%
Preferred stock 20% 8.89% 1.78%
Common stock 40% 12.00% 4.80%
8.19%
paid annually. Today the bond is
ch dividend is fixed $ 4 and
ntly paid $2 which is expected
project at a ratio of 40:20:40.
Q.No.3 Find the WACC of Naveed Computers. The total book value of the firm’s equity is $12 million; book value per
share is $22. The stocks sell for a price of $32 per share, and the cost of equity is 16 percent. The firm’s bonds
have a face value of $6 million and sell at a price of 110 percent of face value. The yield to maturity on the
bond is 9 percent, and the firm’s tax rate is 40 percent.

Solution:

Equity 12,000,000 Market Value = No of outstading shares

Book Value 22 545,454.55
P0 32 Market Value = 17,454,545.45
Cost of equity 16%
Bond 6,000,000 No of bonds
Price 1100 6000
YTM 9% = 6,600,000.00
Tax 40%
5.4%
5.4%
Investment Required
Security Market Value Weightage WACC
return
Debt 6,600,000 27.44% 5.4% 0.89%
Common stock 17,454,545 72.56% 16% 11.61%
24,054,545 12.50%

David Ortiz Motors has a target capital structure of 40 percent debt and 60 percent equity.
The yield to maturity on the company’s outstanding bonds is 9 percent, and the company’s tax rate is 40 percent.
Ortiz’s CFO has calculated the company’s WACC as 9.96 percent. What is the company’s cost of equity capital?

Capital StructuRequired Return

40 5.40%
60 ?
9.96%
12 million; book value per
percent. The firm’s bonds
ield to maturity on the

utstading shares x Market Value per share

32

x 1100

mpany’s tax rate is 40 percent.

any’s cost of equity capital?
Q.No.4 David Ortiz Motors has a target capital structure of 40 percent debt and 60 percent equity. The yield to maturity
on the company’s outstanding bonds is 9 percent, and the company’s tax rate is 40 percent. Ortiz’s CFO has
calculated the company’s WACC as 9.96 percent. What is the company’s cost of equity capital?

Solution:

Bond YTM 9%
Tax 40%
Weight 40%
Wacc 9.96%
Equity Weight 60%
Cost of equity ?

Investment Required
Security Weightage return WACC

Debt 40% 9% 2.16%

Common stock 60% 13.00% 7.80%
9.96%
Cost of equity = 13%
. The yield to maturity
t. Ortiz’s CFO has
Q.No.5 Tunney Industries can issue perpetual preferred stock at a price of $50 a share. The issue is expected to
pay a constant annual dividend of $3.80 a share. The flotation cost on the issue is estimated to be 5
percent. What is the company’s cost of preferred stock, kps?

Solution:

P 50
D 3.80
F 5% 95%
kps ?

kps= D/ P(1 - F)
kps= 3.8 / 50*(1-0.05)
kps= 7.22%
s expected to
Q.No.6 Javits & Sons common stock is currently trading at $30 a share. The stock is expected to pay a dividend
of $3.00 a share at the end of the year (D1= $3.00), and the dividend is expected to grow at a constant
rate of 5 percent a year. What is the cost of common equity?

Solution:

P0 30
D1 3.00
g 5%
r ?

r= D1/ P0 + g
r= (3.0 / 50) + 5%)
r= 15.00%
y a dividend
t a constant
Q.No.7 The earnings. Dividends, and 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
the company will pay a dividend of $2.15 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 percent, and the expected return on the market is 13
percent, what will be the firm’s cost of equity using the CAPM approach?

Solution:

a) g 7% b) b 1.6
P0 23 rRF 9%
D1 2.15 rM 13%
r ? r= ?
using discoounted cash flow approach using CAPM approach
r= D1/ P0 + g r= rRF + b(rM-rRF)
r= (2.15 / 23) + 7%) r= 9% + 1.6(13% - 9%)
r= 16.35% r= 15.40%
w at 7 percent
s $2.00, and
Q.No.8 Sidman Products stock is currently selling for $60 a share. The firm is expected to earn $5.40 per share this year and t
a. If investors require a 9 percent return, what rate of growth must be expected for Sidman?
b. If Sidman reinvests earnings in projects with average returns equal to the stocks expected rate of return, what will

Solution:

P0 60
EPS1 5.40
D1 3.60
a) r 9%
g ?

g= r - D1/ P0
g= 9% - (3.60 / 60)
g= 3.0%

b) DPR= DPS1 / EPS1

DPR= 3.60 / 5.40
DPR= 66.67%

EPS2= D1(1+g) / DPR

EPS2= 3.60 (1 + 3%) / 66.67%
EPS2= 5.562
0 per share this year and to pay a year-end dividend of $3.60.

d rate of return, what will be next year’s EPS?

Q.No.9 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 percent 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 percent,
consisting of a dividend yield of 4 percent and an expected constant growth rate of 8 percent.
(The next expected dividend is $1.20, so $1.20/$30 = 4 %.) The marginal corporate tax rate is 40 percent.
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?

Solution:
Bond CR 8%
Tax 40%
Common Stock
P0 30
r 12%
Dy 4%
g 8%
D1 1.2

a) Financing Required for new investment= 30,000,000

Current Capital Structure for Equity= 50%
New Investment required for financing
through equity= 15,000,000

b) Security Capital Structure Rate of return WACC

Debt 50% 8% 2.40%
Equity 50% 12% 6.00%
8.40%

c) Issue of new common equity will increase the weightage of equity in the capital structure and in result WACC
will also increase.
 the year, the company plans
structure, shown below, is

12 percent,

ate is 40 percent.
financed by common equity?
capital structure

w shares of stock.

re and in result WACC

Q.No.10 Suppose the Shoof company has this book value balance sheet;
Current assets $ 30,000,000 Current Liabilities $
Fixed assets 50,000,000 Long term debt
Common equity
Common stock (1 million shares)
Retained earnings
Total assets 80,000,000 Total claims

The current liabilities consist entirely of notes payable to banks, and the interest rate on this debt is 10 percent,
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 $1000, carries an annual coupon interest rate of 6 percent, and matures in 20 years. The going rate of
interest on new long-term, rd, is 10 percent, 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.

Solution:
Current Price of Bond $659.46
Current Market Value of LTD 19,783,724
Current Market Value of STD 10,000,000
Current Market Value of CS 60,000,000

Market Value Capital Structure

Market Value Capital Structure
Market Value of CS 60,000,000 66.83%
Market Value of STD 10,000,000 11.14%
Market Value of LTD 19,783,724 22.03%
89,783,724 100%
 10,000,000
30,000,000

1,000,000
39,000,000
80,000,000

te on this debt is 10 percent,

ds, each of which has a par
20 years. The going rate of
y on the bonds. The common
Q.No.11 The following tabulation gives earnings per share figures for Exxon manufacturing during the preceding 10 years.
The firm’s common stock, 140,000 shares outstanding, is now selling for Rs.50 a share, and the expected dividend
for the coming year i.e. 2002 is 50 percent of EPS for the year. Investors expect past trends to continue, so g may
be based on the historical earnings growth rate.
Year EPS
1992 Rs. 2.00
1993 2.16
1994 2.33
1995 2.52
1996 2.72
1997 2.94
1998 3.18
1999 3.43
2000 3.70
2001 4.00
The current interest rate on new debt is 8 percent. The firm’s marginal tax rate is 40 percent. The firm’s market
value capital structure, considered to be optimal, is as follows:
Debt Rs. 3,000,000
Common equity 7,000,000
1. Calculate the firm’s after tax cost of new debt and of common equity, assuming new equity comes only from
reinvested cash flow (assuming constant growth rate)
2. Find the firm’s WACC, assuming no new common stock is sold.

Solution:
1) After-tax cost of new debt= 4.80%
Cost of Common Equity= 12.32%

2) WACC
Weight Cost WACC
Debt Rs. 3,000,000 0.3 4.80% 1.44%
Common equity 7,000,000 0.7 12.32% 8.62%
10.06%
e preceding 10 years.
the expected dividend
to continue, so g may

t. The firm’s market

ty comes only from