ACCOUNTING

ASSIGNMENT #3

The purpose of this assignment is to solidify your understanding on the applications of the cost

of capital topics. The scores of this assignment will help in assessing the following learning goal

of the course: “students successfully completing this course will be able to estimate and interpret

the cost of capital of a firm based on different capital structures”.

Instructions:

You are required to use a financial calculator or spreadsheet (Excel) to solve 10 problems

(provided on page 3) related to the cost of capital. You are required to show the following 3 steps

for each problem (sample questions and solutions are provided for guidance):

(i) Describe and interpret the assumptions related to the problem.

(ii) Apply the appropriate mathematical model to solve the problem.

(iii) Calculate the correct solution to the problem.

Sample Questions and Solutions

Sample Question: A company is expected to pay a $3.50 dividend at year-end, the dividends are expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company’s WACC if all equity is from retained earnings?

Solution

(i) The problem assumes the stock will have a constant growth of 6.5% forever. The constant growth model is appropriate to use for this problem. The accuracy of the solution depends on the correctness of the constant growth assumption. The cost of equity assumes there will not be any new stock issuance. Therefore, the cost of equity is the cost of retained earnings for the existing shareholders. The cost of debt should be on after-tax basis due to the tax shield provided by the interest expense.

(ii) The cost of equity is based on the following: Kre = (D1/P0) + g • P0 is the current price to be calculated, • D1 is the next period’s dividend, • R is the required return on this stock

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• g is the constant growth

The cost of debt is based on kd = rd(1-T)

• rd is the before-tax cost of debt • T is the tax rate

The WACC is based on: WACC = wdkd + wrekre

(iii) Cost of retained earnings = (3.5/62.5) + 0.065 = 0.121 or 12.1% Cost of debt = 7.5 x (1-0.4) = 4.5% WACC = (0.4×4.5) + (0.6×12.1) = 9.06%

The average cost of capital for this company based on their existing debt and equity is 9.06%

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Assignment Problems

1. XYZ company is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be $50 per bond. The marginal tax rate is 35%. What is the post-tax cost of debt for the newly-issued bonds?

2. ABC Corporation will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of new common stock?

3. XYZ Inc. will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of internal equity?

4. Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of the selling price. What is the cost of Haroldson Inc.’s new common stock?

5. Kokapeli, Inc. has a target capital structure of 40% debt and 60% common equity, and has a 40% marginal tax rate. If the firm’s yield to maturity on bonds is 7.5% and investors require a 15% return on the firm’s common stock, what is the firm’s WACC?

6. Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock. What is the cost of internal common equity if the long-term growth in dividends is projected to be 8 percent indefinitely?

7. APR Company’s preferred stock is currently selling for $28.00, and pays a perpetual annual dividend of $2.00 per share. New issue of preferred stock would have $3 per share in flotation costs. The firm’s tax rate is 40%. Compute the cost of new preferred stock?

8. ABC Corp. is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Flotation expense on the new bonds will be $50 per bond. The marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?

9. New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60 every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be 4%. If the firm has a 35% marginal tax bracket, what is cost of existing debt?

10. GHJ Inc. is investing in a new project of $16 million. It will raise $2 million of bonds, $4 million of preferred stock, and $10 million of new common stock. If the after-tax cost of debt is 7%, cost of preferred stock is 9%, the cost of retained earnings is 14%, and the cost of new common stock is 17%, what is the WACC?

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Grading Rubric

Learning Objective

Subcomponent Not Submitted

0

Does Not Meet Expectations

1

Meets expectations

2

Exceeds Expectations

3

LO#4: Estimate and interpret the cost of capital of a firm based on different capital structures

The student will make and evaluate important assumptions in identification of appropriate cost of capital measures

No attempt made Attempts to describe assumptions

Explicitly describes assumptions

Explicitly describes assumptions and provides rationale for why each assumption is appropriate. Show awareness that confidence in final conclusions is limited by the accuracy of the assumptions (e.g., provides descriptions about the assumptions of each of the cost of capital components; lists and describes each variable within the model)

The student will convert relevant information into various mathematical forms (e.g., equations, graphs, words)

No attempt made Completes conversion of information but resulting mathematical portrayal is inappropriate or inaccurate

Completes conversion of information into mathematical portrayal

Relevant information is expressed in an insightful mathematical portrayal in a way that contributes to a further or deeper understanding (e.g., correct variables are selected and the mathematical model is portrayed with the correct variables)

The student will calculate the cost of each capital structure component and the average cost of capital

No attempt made Calculations are attempted but are both unsuccessful and not comprehensive

Calculations are attempted to solve the problem but not comprehensive

Calculations attempted are essentially all successful and sufficiently comprehensive to solve the problem. Calculations are also presented elegantly (e.g., provides insights on the interpretation of the cost of capital and its appropriateness within the framework listed in assumptions)

The above rubric will be applied to grade each question and the average score will be calculated for each subcomponent.

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