School of Banking and Finance

FINS5514 Capital Budgeting and Financing Decisions

Tutorial Covering Week 5 – Cost of Capital and Raising capital

Multiple Choice Questions

1. Big Bird & Friends is expected to pay their next annual dividend in the amount of $1.50 a
share. This dividend is expected to increase by 3 percent annually. The company’s stock is
currently selling for $43.20 per share. What is the cost of equity?
a) 6.28 percent
b) 6.37 percent
c) 6.47 percent
d) 6.58 percent

Using the dividend growth model, we have:

𝐷𝐷1 1.50
𝑅𝑅𝐸𝐸 = + 𝑔𝑔 = + 3 = 0.0647 = 6.47%
𝑃𝑃0 43.20
Answer: c

2. Ernie and Fred’s has a beta of 1.06. The risk-free rate of return is 3.5 percent and the market
risk premium is 7 percent. What is the cost of equity?
a) 10.10 percent
b) 10.92 percent
c) 11.13 percent
d) 11.26 percent
Using the CAPM, we have:
𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.35 + 1.06 × 0.07 = 0.1092 = 10.92%
Answer: b

3. An increase in interest rates by the Federal Reserve will cause the cost of debt for a
leveraged firm to:
a) remain at its current rate.
b) increase.
c) decrease.
d) change but the direction of that change cannot be predicted.
For a leveraged firm, increases in interest rates will increase the cost of debt.
Answer: b
4. Alpha Industries manufactures wood products and has a cost of capital of 12 percent. The
Delta Co. is engaged in logging and mining operations and has a 14 percent cost of capital.
Both Alpha and Delta are considering purchasing some land which has just come on the
market and contains several thousand log feet of prime timber. The net present value of
this project is $62,500 at a 12 percent discount rate and a -$14,900 (negative) at a 14
percent discount rate. Which firm or firms, if either, should purchase this land for its
timber?
a) Alpha only
b) Delta only
c) both Alpha and Delta
d) neither Alpha nor Delta
e) Cannot assess the project for either Alpha or Delta with the available information

The proposed project is about logging. It is not in Alpha’s main line of business and thus Alpha’s
cost of capital cannot be used to evaluate the project. Logging is one of Delta’s business but the
cost of capital of 14% for Delta represents the cost for all operations not just logging. Thus, Delta’s
cost of capital cannot be used to evaluate the project. There is not enough information provided
to assess a project specific cost of capital for the logging project for either firm
Answer: e

Alternate question 4
Alpha Industries manufactures wood products and has a cost of capital of 12 percent. The Delta
Co. is engaged in logging operations and has a 14 percent cost of capital. Both Alpha and Delta
are considering purchasing some land which has just come on the market and contains several
thousand log feet of prime timber. The net present value of this project is $62,500 at a 12
percent discount rate and a ‐$14,900 (negative) at a 14 percent discount rate. Which firm or
firms, if either, should purchase this land for its timber?
a) Alpha only
b) Delta only
c) both Alpha and Delta
d) neither Alpha nor Delta

The proposed project is about logging. It is not in Alpha’s main line of business and thus Alpha’s
cost of capital cannot be used to evaluate the project. This is Delta’s main line of business so
using 14% as a discount rate is suitable but the NPV is negative. Assuming that we can use Delta’s
cost of capital of 14% as a proxy for Alphas project cost of capital for the logging project, neither
firm should invest.
Answer: d
Short answer questions
5. The 8.5 percent preferred stock of Flintstone & Daughter is currently selling for $72 a share.
The par value per share is $100. What is the cost of preferred stock for this firm?

First, we need to find the dividend amount which is 8.5% of $100 (the par value). This is $8.5.

Thus:
𝐷𝐷 8.5
𝑅𝑅𝑃𝑃 = = = 0.1181 = 11.81%
𝑃𝑃0 72

6. Your firm has a cost of equity of 11 percent and a pre-tax cost of debt of 9 percent. You maintain a
debt-equity ratio of 0.40 and have a tax rate of 34 percent. What is your firm’s weighted average
cost of capital?

Firstly, find the weights for the debt and equity components of the firm.
A debt-equity ratio of 0.40 means that the total value of the firm is 1.4 of which 0.4 is debt and 1.0 is
equity.
Using the WACC formula without preference shares, we have
𝐸𝐸 𝐷𝐷 1.0 0.4
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = � � 𝑅𝑅𝐸𝐸 + �� � 𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇)� = � � 0.11 + �� � 0.09 × (1 − 0.34)�
𝑉𝑉 𝑉𝑉 1.4 1.4
= 0.0955 = 9.55%

7. The Brilliant Co. has an overall cost of equity of 10 percent and a beta of 1.20. The risk-free rate of
return is 4 percent. The firm is considering a project with a beta of 0.97 and a four-year life. What
is an appropriate cost of equity for this project?

Using the CAPM, we find the market risk premium (MRP) using the information about the firm:

𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.10 = 0.04 + 1.20 × (𝑀𝑀𝑀𝑀𝑀𝑀)

𝑀𝑀𝑀𝑀𝑀𝑀 = 0.05

Now looking at the project, we find:

𝑅𝑅𝐸𝐸 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝐸𝐸 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.04 + 0.97 × (0.05) = 0.085 = 8.85%
Long answer questions

8. Target capital structure is 60% common stock, 5% preferred stock, 35% debt. Cost of equity is 12%,
cost of preferred stock is 5% and pretax cost of debt is 7%. Tax rate is 35%.
a. What is the WACC? What is the pre-tax WACC?
b. Looking at these figures, preferred stock seems to be cheaper than debt, so why not use more?
Explain.

a. Using the equation for WACC and adjusting for the after-tax cost of debt we have:

𝐸𝐸 𝑃𝑃 𝐷𝐷
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = � � 𝑅𝑅𝐸𝐸 + � � 𝑅𝑅𝑃𝑃 + �� � 𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇)�
𝑉𝑉 𝑉𝑉 𝑉𝑉
= 0.6 × 0.12 + 0.05 × 0.05 + [0.35 × 0.07 × (1 − 0.35)] = 0.0904
= 9.04%

𝐸𝐸 𝑃𝑃 𝐷𝐷
𝑃𝑃𝑃𝑃𝑃𝑃 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = � � 𝑅𝑅𝐸𝐸 + � � 𝑅𝑅𝑃𝑃 + � � 𝑅𝑅𝐷𝐷 = 0.6 × 0.12 + 0.05 × 0.05 + 0.35 × 0.07
𝑉𝑉 𝑉𝑉 𝑉𝑉
= 0.099 = 9.9%
b. These figures are misleading as they use the pretax cost of debt and it is the after-tax cost of debt that
is important. The after-tax cost is 0.07(1-0.35) = 4.55% which is cheaper than preferred stock and this
is why the firm uses more debt than preference shares.

9. An all-equity firm is considering these projects:

Project Beta IRR
W 0.6 8.80%
X 0.85 9.5
Y 1.15 11.9
Z 1.45 15

The t-bill rate is 4%, expected returns on the market is 11%

a. Which projects have a higher expected return than the firms’ 11% overall cost of capital?
b. Which projects should be accepted?
c. Which projects would be incorrectly accepted or rejected is the firm’s overall cost of capital
were used as a hurdle rate?

a. Projects Y and Z have IRR’s that exceed the 11% firm cost of capital.

b. Using the CAPM to consider the projects, we can calculate the expected return of the project
given its level of risk. This expected return should then be compared to the IRR of the project.
Recall that the IRR is the discount rate that gives NPV = 0 so if the expected return on the project
is lower than the IRR, then the project will make money.
 𝑅𝑅𝑊𝑊 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑊𝑊 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.04 + 0.6 × (0.11 − 0.04) = 0.0820 < 0.088 Accept W
𝑅𝑅𝑋𝑋 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑋𝑋 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.04 + 0.85 × (0.11 − 0.04) = 0.0995 > 0.095 Reject X
𝑅𝑅𝑌𝑌 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑌𝑌 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.04 + 1.15 × (0.11 − 0.04) = 0.1205 > 0.119 Reject Y
𝑅𝑅𝑍𝑍 = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑍𝑍 × �𝑅𝑅𝑀𝑀 − 𝑅𝑅𝑓𝑓 � = 0.04 + 1.45 × (0.11 − 0.04) = 0.1415 < 0.150 Accept Z

c. Using 11% as the hurdle rate we would incorrectly reject project W, as its expected return is only
8.2%. Project Y would be incorrectly accepted.

10. A firm needs to raise $55 million for a new project and raises the money by selling securities. Target
capital structure is 70% common stock, 5% preferred stock and 25% debt. Floatation costs for new
common stock as 9%, for new preferred stock are 6% and for new debt 3%. What is the true initial
cost figure that the company should use when evaluating the project?

The total floatation cost is the weighted average of the individual floatation costs:
𝐸𝐸 𝑃𝑃 𝐷𝐷
𝑓𝑓𝐴𝐴 = � � 𝑓𝑓𝐸𝐸 + � � 𝑓𝑓𝑃𝑃 + � � 𝑓𝑓𝐷𝐷 = (0.07 × 0.09) + (0.05 × 0.06) + (0.025 × 0.03) = 0.0735
𝑉𝑉 𝑉𝑉 𝑉𝑉
= 7.35%
Therefore, the total cost of the equipment including flotation costs is:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × (1 − 0.0735) = $55,000,000
55,000,000
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = = $59,363,195
(1 − 0.0735)

11. A firm is considering a project which will result in initial after-tax savings of $1.8 million at the end
of the first year and these savings will grow at a rate of 2% per year indefinitely. The firm has a
target debt-equity ratio of 0.80, a cost of equity of 12% and an after-tax cost of debt of 4.8%. The
cost-saving proposal is somewhat riskier than the usual firm investment; the management employs
a subjective approach and applies an adjustment of factor or +2% to the cost of capital for such
projects. Should the firm take the project?

Start by calculating the firm WACC

𝐸𝐸 𝐷𝐷 1.0 0.8
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = � � 𝑅𝑅𝐸𝐸 + �� � 𝑅𝑅𝐷𝐷 × (1 − 𝑇𝑇)� = � � 0.12 + �� � (0.048)� = 0.0880 = 8.80%
𝑉𝑉 𝑉𝑉 1.8 1.8

Since the project is riskier than the company, we need to adjust the project discount rate for the
additional risk. Using the subjective risk factor given, we find:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 8.80% + 2.00% = 10.80%
The NPV is the PV of the cash outflows plus the PV of the cash inflows. In this case, the cash inflows
are a growing perpetuity. The equation for the PV of a growing perpetuity is:
𝐶𝐶 1,800,000
𝑃𝑃𝑃𝑃𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = = = $20,454,545
𝑟𝑟 − 𝑔𝑔 (0.1080 − 0.02)
The project should only be undertaken if its cost is less than $20,454,545 since costs less than this
amount will result in a positive NPV.