Question

8. The calculation of WACC involves calculating the weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of financing in the firm’s overall capital structure.

1. BLANK is the symbol that represents the required rate of return on preferred stock in the weighted average cost of capital (WACC) equation. Options rps / rstd/ rd/ rs

2. Mitchell Co. has $3.9 million of debt, $2 million of preferred stock, and $3.3 million of common equity. What would be its weight on common equity?

0.36

0.20

0.24

0.22

A firm’s cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions:

Wizard Co. currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions. Its beta is currently 1.3. The risk-free rate is 4.8%, and the market risk premium is 5.8%.

This means that the firm’s real estate division will have a cost of capital of:

9.60%

12.34%

11.04%

3.36%

The consulting division is expected to have a beta of 2.0, because it will be riskier than the firm’s real estate division.

This means that the firm’s consulting division will have a cost of capital of:

17.35%

17.75%

18.90%

16.40%

The distribution division will have less risk than the firm’s real estate division, so its beta is expected to be 0.6.

This means that the distribution division’s cost of capital will be:

18.45%

18.35%

17.15%

8.28%

Wizard Co. expects 60% of its total value to end up in the real estate division, 25% in the consulting division, and 15% in the distribution division.

Based on this information, what rate of return should its investors require once it opens the new divisions? (Note: Round your intermediate calculations to two decimal places.)

14.05%

12.75%

17.50%

15.60%

Answer 1

Answer to Question 1.
Value of Debt = $3,900,000
Value of Preferred Stock = $2,000,000
Value of Common Equity = $3,300,000
Value of Firm = $3,900,000 + $2,000,000 + $3,300,000
Value of Firm = $9,200,000

Weight of Common Equity = $3,300,000 / $9,200,000
Weight of Common Equity = 0.36

Answer to Question 2.
Cost of Capital = Risk Free Rate + Beta * Market Risk Premium
Cost of Capital of Real Estate Division = 4.8% + 1.3 * 5.8%
Cost of Capital of Real Estate Division = 4.8% + 7.54%
Cost of Capital of Real Estate Division = 12.34%

Answer to Question 3.
Cost of Capital = Risk Free Rate + Beta * Market Risk Premium
Cost of Capital of Consulting Division = 4.8% + 2.0 * 5.8%
Cost of Capital of Consulting Division = 4.8% + 11.6%
Cost of Capital of Consulting Division = 16.40%

Answer to Question 4.
Cost of Capital = Risk Free Rate + Beta * Market Risk Premium
Cost of Capital of Distribution Division = 4.8% + 0.6 * 5.8%
Cost of Capital of Distribution Division = 4.8% + 3.48%
Cost of Capital of Distribution Division = 8.28%

Answer to Question 5.

Rate of Return = (0.60 * 12.34%) + (0.25 * 16.40%) + (0.15 * 8.28%)
Rate of Return = 12.75%