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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%.

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.)

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.

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?

6 Finding the WACC Given the following information for Huntington Power Co.,

find the WACC. Assume the company’s tax rate is 35 percent.

Debt: 5,000, 6 percent coupon bonds outstanding, $1,000 par

value, 25 years to maturity, selling for 105 percent of par; the bonds make

semiannual payments.

Common stock: 175,000 shares outstanding, selling for $58 per share; the beta is

1.10.

Market: 7 percent market risk premium and 5 percent risk-free rate.

7 Finding the WACC Titan Mining Corporation has 9.3 million shares of

common stock outstanding and 260,000 6.8 percent semiannual bonds

outstanding, par value $1,000 each. The common stock currently sells for $34 per

share and has a beta of 1.20, and the bonds have 20 years to maturity and sell for

104 percent of par. The market risk premium is 7 percent, T-bills are yielding 3.5

percent, and Titan Mining’s tax rate is 35 percent.

8 Lancaster Engineering Inc. (LEI) has the following capital structure, which it

considers to be optimal:

Debt 25%

Preferred stock 15

Common equity 60

100%

LEI’s expected net income this year is $34 285 72; its federal-plus-state tax rate is

40%; and investors expect future earnings and dividends to grow at a constant rate

of 9%. LEI paid a dividend (D0), of $3 60 per share last year, and its stock currently

sells for $54 00 per share. An average stock has 14% expected rate of return and

Beta is 1.51. Risk free rate is 11%.

LEI can obtain new capital in the following ways:

• New preferred stock with a dividend of $11 00 can be sold to the public at a price

of $95 00 per share.

• Debt can be sold at an interest rate of 12%.

Calculate the WACC.

9 Klose Outfitters Inc. believes that its optimal capital structure consists of 60%

common equity and 40% debt, and its tax rate is 40%. Klose must raise additional

capital to fund its upcoming expansion. The firm will have $2 million of retained

earnings with a cost of rs 12%. New common stock in an amount up to $6 million

would have a cost of re 15%. Furthermore, Klose can raise up to $3 million of debt

at an interest rate of rd 10% and an additional $4 million of debt at rd 12%. The

CFO estimates that a proposed expansion would require an investment of $59

million. What is the WACC for the last dollar raised to complete the expansion

10 . Shi Importer’s balance sheet shows $300 million in debt, $50 million in

preferred stock, and $250 million in total common equity. Shi’s tax rate is 40%, rd

= 6%, rps = 5.8%, and rs = 12%. If Shi has a target capital structure of 30% debt,

5% preferred stock, and 65% common stock, what is its WACC?

11. On January 1, the total market value of the Tysseland Company was $60

million. During the year, the company plans to raise and invest $30 million in new

projects. The firm’s present market value capital structure, shown below, is

considered to be optimal. There is no short-term debt.

Debt $30,000,000

Common equity 30,000,000

Total capital $60,000,000

New bonds will have an 8% coupon rate, and they will be sold at par. Common

stock is currently selling at $30 a share. The stockholders’ required rate of return is

estimated to be 12%, consisting of a dividend yield of 4% and an expected constant

growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is

$1.20/$30 = 4%.) The marginal tax rate is 40%.

a. In order to maintain the present capital structure, how much of the new investment

must be financed by common equity?

b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital

structure without issuing additional shares of equity, what is its WACC?

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