Chapter 9
BFIN525
(9-1)
Cost of Debt
Calculate the after-tax cost of debt under each of the following conditions:
a. Interest rate of 13%, tax rate of 0%
b. Interest rate of 13%, tax rate of 20%
c. Interest rate of 13%, tax rate of 35%
a. rd(1 - T) = 13%(1 - 0) = 13.00%.
b. rd(1 - T) = 13%(0.80) = 10.40%.
c. rd(1 - T) = 13%(0.65) = 8.45%.
(9–2)
After-Tax Cost of Debt
LL Incorporated’s currently outstanding 11% coupon bonds have a yield to
maturity of 8%. LL believes it could issue new bonds at par that would
provide a similar yield to maturity. If its marginal tax rate is 35%, what is
LL’s after-tax cost of debt?
rd(1 - T) = 0.08(0.65) = 5.2%.
(9–3)
Cost of Preferred Stock
Duggins Veterinary Supplies can issue perpetual preferred stock at a price of
$50 a share with an annual dividend of $4.50 a share. Ignoring flotation
costs, what is the company’s cost of preferred stock, rps?
If floatation cost is 10% then
R ps = 4.5 / 50(1-0.1) = 10%
(9–4)
Cost of Preferred Stock with Flotation Costs
Burnwood Tech plans to issue some $60 par preferred stock with a 6%
dividend. A similar stock is selling on the market for $70. Burnwood must
pay flotation costs of 5% of the issue price. What is the cost of the preferred
stock?
(9–5)
Cost of Equity: DCF
Summerdahl Resort’s common stock is currently trading at $36 a share. The
stock is expected to pay a dividend of $3.00 a share at the end of the year
(D1 = $3.00), and the dividend is expected to grow at a constant rate of 5% a
year. What is its cost of common equity?
Note if we have the current div instead of expected div is the given as: The
current div (Div 0) is 2.857$.
Then you have to calculate Div 1 or expected div as:
Div1 = Div0(1+g) = 2.857(1+0.05) = 3$
(9–6)
Cost of Equity: CAPM
Booher Book Stores has a beta of 0.8. The yield on a 3-month T-bill is 4%
and the yield on a 10-year T-bond is 6% (risk free: yield on treasury bond).
The market risk premium is 5.5%, and the return on an average stock in the
market last year was 15%.
What is the estimated cost of common equity using the CAPM?
(9–7)
WACC
Shi Importer’s balance sheet shows $300 million in debt, $50 million in
preferred stock, and $250 million in total common equity.
Total capital = total debt + total ps + total common equity = $600 Million
Weight of debt on balance sheet = 300 / 600 = 50%
Weight of PS on balance sheet = 50/ 600 = 8.333%
Weight of common equity on balance sheet =250 / 600 = 41.67%
Shi’s tax rate is 40%, rd = 6%, rps =5.8%, and rs = 12%. If Shi has a target
capital structure of 30% debt, 5% preferred stock, and 65% common stock,
what is its WACC?
(9–8)
WACC
David Ortiz Motors has a target capital structure of 40% debt and 60%
equity. The yield to maturity on the company’s outstanding bonds is 9%, and
the company’s tax rate is 40%. Ortiz’s CFO has calculated the company’s
WACC as 9.96%. What is the company’s cost of equity capital?
(9–10)
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 (Div0) was $2.00, and the company will pay a dividend of
$2.14(at the end of the current year.
Div1 = Div0(1+g)=2(1.07)=2.14
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%, then what would be the firm’s cost of equity based on
the CAPM approach?
c. If the firm’s bonds earn a return of 12%, then what would be your
estimate of rs using the over-own-bond-yield-plus-judgmental-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 be your
estimate of Shelby’s cost of equity?
(9–11)
Cost of Equity
Radon Homes’ current EPS is $6.50. It was $4.42 five years ago.
EPS 0 = $4.42
EPS 5 = $6.50
EPS5 = EPS0(1+g)^5
The company pays out 40% of its earnings as dividends, and the stock sells
for $36.
a. Calculate the historical growth rate in earnings. (Hint: This is a 5-year
growth period.)
b. Calculate the next expected dividend per share, D1. (Hint: D0 =
0.4($6.50) =$2.60.)
Assume that the past growth rate will continue.
c. What is Radon Homes’ cost of equity, rs?