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# Cost of Capital

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? Complete problems 1, 3, 4, 7, 10, & 12 on text pp. 383-386 of Ch. 12.

1. Calculate the after-tax cost of a \$25 million debt issue that Pullman
Manufacturing Corporation (40 percent marginal tax rate) is planning to
place privately with a large insurance company. This long-term issue will yield
6.6 percent to the insurance company.

3. Calculate the after-tax cost of preferred stock for Bozeman-Western Airlines,
Inc., which is planning to sell \$10 million of \$4.50 cumulative preferred stock
to the public at a price of \$48 a share. The company has a marginal tax rate of
40 percent.

4. The following financial information is available on Fargo Fabrics, Inc.:
Current per-share market price 5 \$20.25
Current per-share dividend 5 \$1.12
Current per-share earnings 5 \$2.48
Beta 5 0.90
Expected market risk premium 5 6.4%
Risk-free rate (20-year Treasury bonds) 5 5.2%
Past 10 years earnings per share:
20X1 \$1.39 20X6 \$1.95
20X2 1.48 20X7 2.12
20X3 1.60 20X8 2.26
20X4 1.68 20X9 2.40
20X5 1.79 20Y0 2.48

This past-earnings growth trend is expected to continue for the foreseeable
future. The dividend payout ratio has remained approximately constant over
the past 10 years and is expected to remain at current levels for the foreseeable
future.

Calculate the cost of equity capital using the following methods:
a. The constant growth rate dividend capitalization model approach
b. The Capital Asset Pricing Model approach

7. The Ewing Distribution Company is planning a \$100 million expansion of its
chain of discount service stations to several neighboring states. This expansion
will be financed, in part, with debt issued with a coupon interest rate of 6.8
percent. The bonds have a 10-year maturity and a \$1,000 face value, and they
will be sold to net Ewing \$990 per bond. Ewing's marginal tax rate is 40 percent.
Preferred stock will cost Ewing 7.5 percent after taxes. Ewing's common
stock pays a dividend of \$2 per share. The current market price per share is \$35.
Ewing's dividends are expected to increase at an annual rate of 5 percent for the
foreseeable future. Ewing expects to generate sufficient retained earnings to
meet the common equity portion of the funding needed for the expansion.
Ewing's target capital structure is as follows:
Debt 5 20%
Preferred stock 5 5%
Common equity 5 75%
Calculate the weighted cost of capital that is appropriate to use in evaluating
this expansion program.

10. The Comfort Corporation manufactures sofas and tables for the recreational
vehicle market. The firm's capital structure consists of 60 percent common
equity, 10 percent preferred stock, and 30 percent long-term debt. This capital
structure is believed to be optimal. Comfort will require \$120 million to
finance expansion plans for the coming year. The firm expects to generate
enough internal equity to meet the equity portion of its expansion needs. The
cost of retained earnings is 18 percent. The firm can raise preferred stock at a
cost of 15 percent. First-mortgage bonds can be sold at a pretax cost of 14
percent. The firm's marginal tax rate is 40 percent.
Calculate the cost of capital for the funds needed to meet the expansion
goal.

12. Rolodex, Inc. would like to estimate its average cost of capital for the coming
year. The capital budgeting plans call for funds totaling \$200 million for the
coming year. These funds will be raised from long-term debt, preferred stock,
and common equity in the same proportions as their book values in the firm's
balance sheet shown below:

Discussions between the firm's financial officers and the firm's investment
and commercial bankers have yielded the following information:
? Rolodex's maximum borrowing is \$80 million from its bank at a pretax
cost of 13 percent.
? Preferred stock can be issued at a pretax cost of 16.5 percent.
? Rolodex expects to generate \$140 million in net income. Any earnings
remaining after meeting the equity portion of the \$200 million capital
expenditure budget will be paid out as dividends.
? The risk-free rate of return is 5.5 percent. The market risk premium is assumed
to equal 10 percent and Rolodex's beta is estimated to be 1.2.
? Rolodex's marginal tax rate is 40 percent.
Compute Rolodex's weighted average cost of capital for the coming year.

#### Solution Preview

? Complete problems 1, 3, 4, 7, 10, & 12 on text pp. 383-386 of Ch. 12.

1. Calculate the after-tax cost of a \$25 million debt issue that Pullman
Manufacturing Corporation (40 percent marginal tax rate) is planning to
place privately with a large insurance company. This long-term issue will yield
6.6 percent to the insurance company.

After tax cost of debt for Pullman = Yield on debt X (1-tax rate)
= 6.6% X (1-0.4) = 3.96%

3. Calculate the after-tax cost of preferred stock for Bozeman-Western Airlines,
Inc., which is planning to sell \$10 million of \$4.50 cumulative preferred stock
to the public at a price of \$48 a share. The company has a marginal tax rate of
40 percent.

Preferred stock is a perpetuity and the cost is given as Annual Dividend/Price. Since the dividend is paid after tax, the cost is the after tax cost
After tax cost of preferred stock for Bozeman-Western Airlines = 4.50/48 = 9.37%

4. The following financial information is available on Fargo Fabrics, Inc.:
Current per-share market price 5 \$20.25
Current per-share dividend 5 \$1.12
Current per-share earnings 5 \$2.48
Beta 5 0.90
Expected market risk premium 5 6.4%
Risk-free rate (20-year Treasury bonds) 5 5.2%
Past 10 years earnings per share:
20X1 \$1.39 20X6 \$1.95
20X2 1.48 20X7 2.12
20X3 1.60 20X8 2.26
20X4 1.68 20X9 2.40
20X5 1.79 20Y0 2.48
This past-earnings growth trend is expected to continue for the foreseeable
future. The dividend payout ratio has remained approximately constant over
the past 10 years and is expected to remain at current levels for the foreseeable
future.
Calculate the cost of equity capital using the following methods:
a. The constant growth rate dividend capitalization model approach

Using the constant growth model, the cost of equity is ...

#### Solution Summary

The solution explains various problems relating to cost of capital

\$2.19