1. A company is 40% financed by risk-free debt.

The interest rate is 10%, the

expected market risk premium is 8%, and the beta of the company’s common
stock is .5. What is the company cost of capital? What is the after-tax WACC,
assuming that the company pays tax at a 35% rate?
2. Currently, Bloom Flowers Inc. has a capital structure consisting of
20% debt and 80% equity. Bloom’s debt currently has an 8% yield to maturity. The
risk-free
rate (rRF) is 5%, and the market risk premium (rM − rRF) is 6%. Using the CAPM,
Bloom estimates that its cost of equity is currently 12 5%. The company has a 40%
tax rate.
a. What is Bloom’s current WACC?
b. What is the current beta on Bloom’s common stock?
c. What would Bloom’s beta be if the company had no debt in its capital structure?
(That is, what is Bloom’s unlevered beta, bU?)
Bloom’s financial staff is considering changing its capital structure to 40% debt and
60% equity. If the company went ahead with the proposed change, the yield to
maturity on the company’s bonds would rise to 9 5%. The proposed change will
have no effect on the company’s tax rate.
d. What would be the company’s new cost of equity if it adopted the proposed
change in capital structure?
e. What would be the company’s new WACC if it adopted the proposed change in
capital structure?
f. Based on your answer to Part e, would you advise Bloom to adopt the proposed
change in capital structure? Explain.
 3 Omega Corporation has 10 million shares outstanding, now trading at $55
per share. The firm has estimated the expected rate of return to shareholders
at about 12%. It has also issued long-term bonds at an interest rate of 7%. It
pays tax at a marginal rate of 35%.

a. What is Omega’s after-tax WACC?

b. How much higher would WACC be if Omega used no debt at all? (Hint:
For this problem you can assume that the firm’s overall beta is not affected by
its capital structure or the taxes saved because debt interest is tax-deductible.)

4 Longstreet Communications Inc. (LCI) has the following capital structure,

which it considers to be optimal: debt _ 25%, preferred stock _ 15%, and
common stock _ 60%. LCI’s tax rate is 40 percent and investors expect
earnings and dividends to grow at a constant rate of 9 percent in the future.
LCI paid a dividend of $3.60 per share last year (D0), and its stock currently
sells at a price of $60 per share. Treasury bonds yield 11 percent; an average
stock has a 14 percent expected rate of return; and LCI’s beta is 1.51. These
terms would apply to new security offerings:
Preferred: New preferred could be sold to the public at a price of $100 per
share, with a dividend
of $11. Flotation costs of $5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 12 percent.
a. Find the component costs of debt, preferred stock, and common stock.
Assume LCI does
not have to issue any additional shares of common stock.
b. What is the WACC?
5 The stock of Gao Computing sells for $55, and last year’s dividend was
$2.10. A flotation cost of 10 percent would be required to issue new common stock.
Gao’s preferred stock pays a dividend of $3.30 per share, and new preferred could
be sold at a price to net the company $30 per share. Security analysts are projecting
that the common dividend will grow at a rate of 7 percent a year. The firm can also
issue additional long-term debt at an interest rate (or before-tax cost) of 10 percent,
and its marginal tax rate is 35 percent. The market risk premium is 6 percent, the
risk-free rate is 6.5 percent, and Gao’s beta is 0.83. In its cost of capital calculations,
Gao uses a target capital structure with 45 percent debt, 5 percent preferred stock,
and 50 percent common equity. what is the company’s WACC?