CHAPTER 8: COST OF CAPITAL

A. True/ False Questions (5)

1. The company cost of capital is the correct discount rate for all projects because the
high risks of some projects are offset by the low risk of other projects.
2. Distant cash flows are riskier than near-term cash flows. Therefore long-term
projects require higher risk-adjusted discount rates.
3. Flotation costs are incurred by a company when it issues new securities and incurs
expenses, such as underwriting fees, legal fees, and registration fees.
4. The yield to maturity on outstanding debt is a better measure of the cost of debt
than the coupon rate.
5. There are a number of factors that can affect a firm's cost of capital. Some are
controllable by that firm, such as capital budgeting decision, dividend payout ratio,
general level of stock prices and capital structure.

B. Multiple Choice Questions (10)

1. The expected return on any asset is dependent on its beta. Thus, we showed how
to estimate the beta of a stock. The appropriate procedure employs ______ analysis
on _______ returns.
A. regression, current
B. regression, historical
C. DuPont, historical
D. DuPont, current

2. In a CAPM model to estimate a firm's cost of equity, we use the formula: R = Rf +

B(Rm-Rf). What is Rf?
A. firms' expected return
B. expected rate of return of market portfolio
C. correlation coefficients
D. risk-free rate

3. The beta of a company is a function of a number of factors. Which is not one of

those factors?
A. Tax rate
B. Cyclicality of revenues
C. Operating leverage
D. Financial leverage
4. If the project’s beta differs from that of the firm, the discount rate should be based
on the ______’s beta. We can generally estimate the project’s beta by determining
the average beta of the project’s ______.
A. firm, firm
B. firm, industry
C. project, industry
D. project, firm

5. New projects are often funded by bonds and stock. The costs of issuance,
generally called _______ costs, should be included in any NPV analysis.
A. flotation
B. legal procedure
C. funding
D. operating

6. Companies prefer to use ____ before offering new common stock because ____
are cheaper and less risky for companies than offering new common stock.
A. preferred stock
B. retained earnings
C. bank loans
D. corporate bonds

7. Torch Industries can issue perpetual preferred stock at a price of $57.00 a share.
The stock would pay a constant annual dividend of $6.00 a share. What is the
company’s cost of preferred stock, rp?
A. 8.5%
B. 11.76%
C. 7.8%
D. 10.53%
8. Jarett & Sons’s common stock currently trades at $30.00 a share. It is expected to
pay an annual dividend of $1.00 a share at the end of the year (D1=$1.00), and the
constant growth rate is 4% a year. What is the company’s cost of common equity if
all of its equity comes from retained earnings?
A. 7.33%
B. 7.8%
C. 8.32%
D. 8.96%

9. Consider the Jarett & Sons in Question 8. If the company issued new stock, it
would incur a 10% flotation cost. What would be the cost of equity from new stock?
A. 7.33%
B. 7.55%
C. 7.7%
D. 8.15%

10. Palencia Paints Corporation has a target capital structure of 35% debt and 65%
common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its
marginal tax rate is 40%. The current stock price is $22.00. The last dividend was
$2.25, and it is expected to grow at a 5% constant rate. What is its WACC?
A. 11.32%
B. 10.18%
C. 11.91%
D. 10.98%

C. Short answer (5)

1. (i) What are the two approaches that can be used to adjust for flotation costs?

(ii) Would a firm that has many good investment opportunities be likely to have a
higher or a lower dividend payout ratio than a firm with few good investment
opportunities? Explain.
2. (i)Why is the after-tax cost of debt rather than the before-tax cost used to calculate
the WACC?

(ii) Why is the relevant cost of debt the interest rate on new debt, not that on already
outstanding, or old, debt?

3. (i) Identify the firm’s three major capital structure components.

(ii) Why might there be two different component costs for common equity? Which one
is generally relevant, and for what type of firm is the second one likely to be relevant?

4. The after-tax WACC is the correct discount rate for projects that have the same
market risk as the company’s existing business. However, in fact, many firms use after-
tax WACC to discount for all project. Why is that practice considered as dangerous?

5. Using the CAPM model to estimate the cost of equity are commonplace across
corporations. Beta is widely considered as the most important in CAPM formula. How
do firms estimate Beta in practice?
D. Exercise: 5

Problem 1: Lancaster Engineering Inc. (LEI) has the following capital structure, which
it considers to be optimal:
Debt 25%; Preferred stock 15%; Common equity 60%
LEI’s expected net income this year is $34,285.72, its established dividend payout
ratio is 30%, tax rate is 40%, and investors expect future earnings and dividends to
grow at a constant rate of 9%. LEI paid a dividend of $3.60 per share last year, and its
stock currently sells for $54.00 per share. LEI can obtain new capital in the following
ways: (1) New preferred stock with a dividend of $11.00 can be sold to the public at a
price of $95.00 per share. (2) Debt can be sold at an interest rate of 12%.
a. Determine the cost of each capital component.
b. Calculate the WACC.
c. LEI has the following investment opportunities that are average-risk projects:
Project Cost at t=0 Rate of Return
A $10,000 17.4%
B $20,000 16.0%
C $10,000 14.2%
 D $20,000 13.2%
E $10,000 12.0%
Which projects should LEI accept? Why? Assume that LEI does not want to issue any
new common stock.
Problem 2:

An oil company executive is considering investing $10 million in one or both of two
wells: Well 1 is expected to produce oil worth $3 million a year for 10 years; Well 2 is
expected to produce $2 million for 15 years. These are real (inflation-adjusted) cash
flows.

The beta for producing wells is .9. The market risk premium is 8%, the nominal risk-
free interest rate is 6%, and expected inflation is 4%.

The two wells are intended to develop a previously discovered oil field.
Unfortunately there is still a 20% chance of a dry hole in each case. A dry hole means
zero cash flows and a complete loss of the $10 million investment.

Ignore taxes and make further assumptions as necessary.

a. What is the correct real discount rate for cash flows from developed wells?

b. The oil company executive proposes to add 20 percentage points to the real
discount rate to offset the risk of a dry hole. Calculate the NPV of each well with this
adjusted discount rate.

c. What do you say the NPVs of the two wells are?

d. Is there any single fudge factor that could be added to the discount rate for
developed wells that would yield the correct NPV for both wells? Explain.

Problem 3: The total market value of the common stock of the Okefenokee Real
Estate Company is $6 million, and the total value of its debt is $4 million. The
treasurer estimates that the beta of the stock is currently 1.5 and that the expected
risk premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity
that Okefenokee debt is risk-free and the company does not pay tax.

a. What is the required return on Okefenokee stock?

b. Estimate the company cost of capital.

c. What is the discount rate for an expansion of the company’s present business?
Problem 4: You are given the following information for Golden Fleece Financial:
Long-term debt outstanding $300,000
Current yield to maturity 8%
Number of shares of common 10,000
stock
Price per share $50
Book value per share $25
Expected rate of return on 15%
stock
Calculate Golden Fleece’s company cost of capital. Ignore taxes

Problem 5:
Nero Violins has the following capital structure:
Security Beta Total Market Value ($ million)
Debt 0 100
Preferred 0.20 40
stock
Common stock 1.20 299

a. What is the firm’s asset beta? (Hint: What is the beta of a portfolio of all the firm’s
securities?)
b. Assume that the CAPM is correct. What discount rate should Nero set for
investments that expand the scale of its operations without changing its asset beta?
Assume a risk-free interest rate of 5% and a market risk premium of 6%.