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Cost of Capital

1.Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable
costs of capital for evaluating average-risk projects, high-risk projects, and low-risk
projects?

Assignment: Weighted Average Cost of Capital

2. The following tabulation gives earnings per share figures for the Foust Company during the
preceding 10 years. The firm's common stock, 7.8 million shares outstanding, is now (1/1/03)
selling for $65 per share, and the expected dividend at the end of the current year (2003) is
55 percent of the 2002 EPS. Because investors expect past trends to continue, g may be based
on the earnings growth rate. (Note that 9 years of growth are reflected in the data.)
YEAR EPS YEAR EPS
1993 $3.90 1998 $5.73
1994 4.21 1999 6.19
1995 4.55 2000 6.68
1996 4.91 2001 7.22
1997 5.31 2002 7.80
The current interest rate on new debt is 9 percent. The firm's marginal tax rate is 40 percent.
Its capital structure, considered to be optimal, is as follows:
Debt $104,000,000
Common equity 156,000,000
Total liabilities and equity $260,000,000
a. Calculate Foust's after-tax cost of new debt and common equity. Calculate the cost of equity
as
b. Find Foust's weighted average cost of capital.

Solution Preview

The weighted average cost of capital should be used for projects which have a similar risk profile as the firm and hence should be applicable for average risk projects. Higher risk projects should have a higher WACC since the risk is higher and lower risk projects should have a lower WACC as the risk is lower. The question is how to estimate these rates.
We can use three methods
1. Find a pure play ...

Solution Summary

The solution explains the changes in cost of capital for a project with different risk than average risk. The solution also has the WACC calculation for Foust Company

$2.19