Question

1. Calculate the aftertax cost of debt under each of the following conditions. (Do not round intermediate calculations. Round the final answers to 2 decimal places.)

	Yield		Corporate Tax Rate		Cost of Debt
a	8.0	%	22	%	%
b	14.0	%	36	%	%
c	11.5	%	42	%	%

2.Schuss Inc. can sell preferred shares for $60 with an estimated flotation cost of $3.00. The preferred stock is anticipated to pay $7 per share in dividends.

a. Compute the cost of preferred stock for Schuss Inc. (Round the final answer to 2 decimal places.)

Cost of preferred stock            %

b. Do we need to make a tax adjustment for the issuing firm?

• Yes

• No

3. Ellington Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D₁) of $1.50 per share, and the current price of its common stock is $30 per share. The expected growth rate is 8 percent. (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

a. Compute the cost of retained earnings (K_e).

Cost of retained earnings            %

  

b. If a $2 flotation cost is involved, compute the cost of new common stock (K_n).

Cost of new common stock            %

4. The Tyler Oil Company’s capital structure is as follows:

Debt	35	%
Preferred stock	15
Common equity	50

The aftertax cost of debt is 7 percent; the cost of preferred stock is 10 percent; and the cost of common equity (in the form of retained earnings) is 13 percent.

a-1. Calculate Tyler Oil Company’s weighted average cost of capital. (Round the final answers to 2 decimal places.)

	Weighted Cost
Debt (Kd)	%
Preferred stock (Kp)
Common equity (Ke)
Weighted average cost of capital (Ka)	%

As an alternative to the capital structure shown above for Tyler Oil Company, an outside consultant has suggested the following modifications.

   

Debt	60	%
Preferred stock	5
Common equity	35

Under this new and more debt-oriented arrangement, the aftertax cost of debt is 8.8 percent, the cost of preferred stock is 10.5 percent, and the cost of common equity (in the form of retained earnings) is 15.5 percent.

a-2. Calculate Tyler’s weighted average cost of capital. (Round the final answers to 2 decimal places.)

  

	Weighted Cost
Debt (Kd)	%
Preferred stock (Kp)
Common equity (Ke)
Weighted average cost of capital (Ka)	%

b. Which plan is optimal in terms of minimizing the weighted average cost of capital?

• Plan 1

• Plan 2

5. Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume the following:

Rf	=		7	%
Rm	=		10	%
βj	=		1.6
D1	=	$	0.70
P0	=	$	19
g	=		8	%

    
a. Compute K_j (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

K_j            %

b. Compute K_e (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

K_e            %

Answer 1

Ans.

1.

Yield (a)	(1 - Tax rate) (b)	Cost of Debt (a*b)
8%	0.78	6%
14%	0.64	9%
11.50%	0.58	7%

2.

a)

Cost of Preferred Stock = Dividend / ( Current Price - Flotation Cost)

Cost of Preferred Stock = $7 / ($ 60 - $ 3 ) = 0.1228 or 12.28%

b)

Preferred stock dividends are not a tax deductible expense for the issuing firm and hence no tax adjustment is required.

3.

a)

(D1) = $1.50

current price (P0) = $30  

growth rate = 8%

Ke = D1 / P0 + growth rate = $ 1.5 / $ 30 + 8% = 5% + 8% = 13%

b)

(D1) = $1.50

current price (P0) = $30

Flotation Cost (F) = $2

growth rate = 8%

Kn = D1 / (P0 - F) + growth rate = $ 1.5/ ( $ 30 - $ 2) + 8%

Kn = 5.36% + 8% = 13.36%

4.

a-1)

Tyler Oil Company
	Cost after tax	Weights	Weighted Cost
Debt (Kd)	7%	35%	2.45%
Preferred stock (Kp)	10%	15%	1.50%
Common equity (Ke)	13%	50%	6.50%
Weighted average cost of capital (Ka)		100%	10.45%

a-2)

Tyler Oil Company
	Cost after tax	Weights	Weighted Cost
Debt (Kd)	8.80%	60%	5.28%
Preferred stock (Kp)	10.50%	5%	0.53%
Common equity (Ke)	15.50%	35%	5.43%
Weighted average cost of capital (Ka)		100%	11.23%

b)

The Plan 1 is the better alternative.

Even though the Plan 2 has relatively more debt, the increased costs of all forms of financing more than offset this factor.

5.

a)

K_j (required rate of return on common equity based on the capital asset pricing model).

R_f =7%

R_m=10%

β_j=1.6

Kj = Rf + (Rm - Rf) * Beta

Kj = 7% + ( 10% - 7%) * 1.6

Kj = 7% + 4.8% = 11.8%

b)

K_e (required rate of return on common equity based on the dividend valuation model)

D₁=$0.70

P₀=$19

g=8%

Re = D1 / P0 + g

Re = $ 0.7 / $ 19 + 0.08 = 3.68 % + 8% = 11.68%