Module 2: Cost of Capital

1. Suppose you estimate that eBay’s stock has a beta of 1.45. for UPS beta is 0.79. If the risk-
free interest rate is 3% and you estimate the market’s expected return to be 8%, calculate
the equity cost of capital for eBay and UPS. Which company has a higher cost of equity
capital?

2. Valence Industries wants to know its cost of equity. Its chief financial officer (CFO)
believes the risk-free rate is 5 percent, equity risk premium is 7 percent, and Valence’s
equity beta is 1.5. What is Valence’s cost of equity using the CAPM approach?

3. Here are stock market and Treasury bill returns (in %) between 1994 and 1998:
Year Index T-Bill
Return Return

1994 1.31 3.9

1995 37.43 5.6

1996 23.07 5.21

1997 33.36 5.26

1998 28.58 4.86

What is the average risk premium

4. With the help of the information given, calculate the beta of the company and the cost of
equity
Nasdaq closing Make My Trip
Year T-bill yeild (%) ($) closing ($)
Dec,2010 1.96% 2648.72 24.33
Dec,2011 1.99% 2699.36 24.99
Dec,2012 1.99% 2739.86 25.75
Dec,2013 1.96% 2774.22 26.83
Dec,2014 1.95% 2676.56 26.92
Dec,2015 1.97% 2670.5 26.42
Dec,2016 1.90% 2720.76 27.58
Dec,2017 1.93% 2724.7 28.36
Dec,2018 1.86% 2710.67 29.58
Dec,2019 1.85% 2728.08 29.58
5. Suppose that the beta of a publicly traded company’s stock is 1.3 and that the value of
equity and debt are, respectively, C$540 million and C$720 million. If the marginal tax
rate of this company is 40 percent, what is the asset beta of this company?

6. Suppose we want to find the beta of an unlisted company with debt and equity in a ratio
of 0.4:1.The comparable company operating in the same line of business has a beta of 1.2
and a debt - to - equity ratio of 0.125 the project. The marginal tax rate is 35 percent.
Calculate the beta for the unlisted company

7. Using the dividend discount model, what is the cost of equity capital for Zeller Mining if
the company will pay a dividend of C $ 2.30 next year, has a payout ratio of 30 percent, a
return on equity of 15 percent, and a stock price of C $ 45?

8. Suppose a company has paid dividend of $ 2 per share, a current price of $ 40 per share,
and an expected growth rate of 5 percent. If the flotation costs are 4 percent of the issuance,
the cost of equity will be?

9. Berta Industries stock has a beta of 1.25. The company just paid a dividend of $.40, and
the dividends are expected to grow at 5 percent. The expected return on the market is 12
percent, and Treasury bills are yielding 5.5 percent. The most recent stock price for Berta
is $72. Calculate the cost of equity using CAPM & Dividend method.

10. Miles Avenaugh, an analyst with the Global Company, is estimating a country risk
premium to include in his estimate of the cost of equity capital for Global’s investment in
Argentina. Avenaugh has researched yields in Argentina and observed that the
Argentinean government’s 10-year bond is 9.5 percent. A similar maturity US Treasury
bond has a yield of 4.5 percent. The annualized standard deviation of the Argentina Merval
stock index, a market value index of stocks listed on the Buenos Aires Stock Exchange,
during the most recent year is 40 percent. The annualized standard deviation of the
Argentina dollar-denominated 10-year government bond over the recent period was 28
percent. What is the estimated country risk premium for Argentina based on Avenaugh’s
research?

11. On February 23, 2011, Alabama Power Co. had two issues of ordinary preferred stock
with a $100 par value that traded on the NYSE. One issue paid $4.72 annually per share
and sold for $84 per share. The other paid $4.60 per share annually and sold for $84.50
per share. What is Alabama Power’s cost of preferred stock?

12. Kylie Minogue ltd, issues 11% irredeemable preference shares of the face value of Rs. 100
each. Floatation costs are estimated at 5% of the expected sale price. What is the Kp, if
preference shares are issued at (i) par value, (ii) 10% premium and (iii) 5% discount.
13. Della ltd. has Rs. 100 preference share redeemable at a premium of 10% with 15 years
maturity. The coupon rate is 12%. Floatation cost is 5%. Sale price is Rs. 95 (net).
Calculate the cost of preference shares.

14. Dexter, Inc., is planning to issue new debt at an interest rate of 8 % . Dexter has a 40% tax
rate. What is Dexter's cost of debt capital?

15. Dot.Com has determined that it could issue $ 1,000 face value bonds with an 8 percent
coupon paid semiannually and a fi ve - year maturity at $ 900 per bond. If Dot.Com ’ s
marginal tax rate is 38 percent, its after - tax cost of debt is ?

16. A company issued 10,000, 10% debentures of ` 100 each at a premium of 10% on
1.4.2013 to be matured on 1.4.2018. The debentures will be redeemed on maturity.
Compute the cost of debentures assuming 35% as tax rate.

17. Calculate the explicit cost of debt (after tax) for Annie Lenox limited in each of the
following situations:
Debentures are sold at par and floatation costs are 5%
Debentures are sold at premium of 10% and floatation costs are 5% of issue price
Debentures are sold at discount of 5% and floatation costs are 5% of issue price.
Assume Interest rate on debentures is 10%, face value is Rs. 100 maturity period is 10
years and tax rate is 35%

18. A company issued 10,000, 15% Convertible debentures of ` 100 each with a maturity
period of 5 years. At maturity the debenture holders will have the option to convert the
debentures into equity shares of the company in the ratio of 1:10 (10 shares for each
debenture). The current market price of the equity shares is `12 each and historically the
growth rate of the shares are 5% per annum. Compute the cost of debentures assuming
35% tax rate.

19. A company issued 10,000, 10% debentures of ` 100 each on 1.4.2013 to be matured on
1.4.2018. The company wants to know the current cost of its existing debt and the market
price of the debentures is ` 80. Compute the cost of existing debentures assuming 35% tax
rate using YTM

20. Valence Industries issues a bond to finance a new project. It offers a 5-year, 5 percent
coupon bond. Upon issue, the bond sells at $1,025. What is Valence’s before tax cost of
debt? If Valence’s marginal tax rate is 35 percent, what is Valence’s after-tax cost of debt?
Use YTM to calculate cost of debt
21. Calculate the cost of debt for the below listed companies if the tax rate is 40% and risk
free rate is 3.5%
Company EBIT Interest Category

Disney 6819 821 > $ 5 billion

Aracruz 574 155 < $ 5 billion

Tata chemicals 6263 1215 < $ 5 billion

Bookscape 3575 575 < $ 5 billion

22. Assume that ABC Corporation has the following capital structure: 30 percent debt, 10
percent preferred stock, and 60 percent common stock. ABC Corporation wishes to
maintain these proportions as it raises new funds. Its before-tax cost of debt is 8 percent,
its cost of preferred stock is 10 percent, and its cost of equity is 15 percent. If the
company’s marginal tax rate is 40 percent, what is ABC’s weighted average cost of
capital?

23. Jorge Ricard, a financial analyst, is estimating the costs of capital for the Zeale
Corporation. In the process of this estimation, Ricard has estimated the before-tax costs of
capital for Zeale’s debt and equity as 4 percent and 6 percent, respectively. What are the
after-tax costs of debt and equity if Zeale’s marginal tax rate is a) 30 percent or b) 48
percent?
24. A financial analyst at Buckco Ltd. wants to compute the company ’ s weighted average
cost of capital (WACC) using the dividend discount model (for Ke). The analyst has
gathered the following data: Before - tax cost of new debt 8 percent; Tax rate 40 percent;
Target debt - to - equity ratio 0.8033; Stock price $ 30; Next year ’ s dividend $ 1.50;
Estimated growth rate 7 percent

25. Acme, Inc., is considering a project in the food distribution business. It has a D/E ratio of
2, a marginal tax rate of 40%, and its debt currently has a yield of 14%. Balfor, a publicly
traded firm that operates only in the food distribution business, has a D/E ratio of 1 .5 , a
marginal tax rate of 30%, and an equity beta of 0.9. The risk-free rate is 5%, and the
expected return on the market portfolio is 12%. Calculate WACC for the project of Acme

26. Trumpit Resorts Company currently has 1.2 million common shares (F.V $10 per share)
of stock outstanding and the stock has a beta of 2.2. It also has $ 10 million face value of
bonds that have five years remaining to maturity and 8 percent coupon with semiannual
payments, and they are priced to yield 13.65 percent. Trumpit has learned that it can issue
new common stock at $ 10 a share. The current risk - free rate of interest is 3 percent and
the expected market return is 10 percent. If Trumpit issues up to $ 2.5 million of new
bonds, the bonds will be priced at par and have a yield of 13.65 percent; if it issues bonds
beyond $ 2.5 million, the expected yield will be 16 percent. Trumpit ’ s marginal tax rate
is 30 percent. If Trumpit raises $ 7.5 million of new capital while maintaining the same
debt - to - equity ratio, its weighted average cost of capital is

27. The B.B. Lean Co. has 1.4 million shares of stock outstanding. The stock currently sells
for $20 per share. The firm’s debt is publicly traded and was recently quoted at 93 percent
of face value. It has a total face value of $5 million, and it is currently priced to yield 11
percent. The risk-free rate is 8 percent, and the market risk premium is 7 percent. You’ve
estimated that Lean has a beta of .74. If the corporate tax rate is 34 percent, what is the
WACC of Lean Co.? Use market value weights

28. Erna Corp. has 8 million shares of common stock outstanding. The current share price is
$73, and the book value per share is $7. Erna Corp. also has two bond issues outstanding.
The first bond issue has a face value of $85 million, has a 7 percent coupon, and sells for
97 percent of par. The second issue has a face value of $50 million, has an 8 percent
coupon, and sells for 108 percent of par. The first issue matures in 21 years, the second in
6 years.
a. What are Erna’s capital structure weights on a book value basis?
b. What are Erna’s capital structure weights on a market value basis?
29. Given the following information for Lightning Power Co., find the WACC. Assume the
company’s tax rate is 35 percent.
Debt: 8,000 6.5 percent coupon bonds outstanding, $1,000 par value, 25 years to maturity,
selling for 106 percent of par; the bonds make semiannual payments.
Common stock: 310,000 shares outstanding, selling for $57 per share; the beta is
1.05.
Preferred stock: 15,000 shares of 4 percent preferred stock outstanding, currently selling
for $72 per share.
Market: 7 percent market risk premium and 4.5 percent risk-free rate

30. Georg Schrempp is the CFO of Bayern Chemicals, a large German manufacturer of
industrial, commercial, and consumer chemical products. Bayern Chemicals is privately
owned, and its shares are not listed on an exchange.
The nominal risk-free rate is represented by the yield on the long-term 10-yearGerman
bund, which at the valuation date was 4.5 percent. The average long-term historical equity
risk premium in Germany is assumed at 5.7 percent. Bayern Chemicals’ corporate tax rate
is 38 percent. Bayern Chemicals’ target debt-to-equity ratio is 0.7. Bayern is operating at
its target debt-to-equity ratio. Bayern Chemicals’ cost of debt has an estimated spread of
225 basis points over the 10-year bund. Calculate WACC
Comparable D/E Beta
Co.

British 1.33 1.45

Chemicals

Compagnie 0.94 0.75

Rotterdan 1.13 1.05

31. AB Ltd. estimates the cost of equity and debt components of its capital for different levels
of debt; equity mix as follows:
Debt as % of Cost of Debt
Cost of Equity
Total capital (before tax)

0 16 12

20 16 12

40 20 16

60 24 20
Suggest the best equity debt mix for the company. Tax rate is 50%
32. Alan Conlon is the CFO of Allied Canadian Breweries Ltd. He wants to determine the
capital structure that will result in the lowest cost of capital for Allied. The minimum rate
at which the company can borrow is the 12-month Libor rate plus a premium that varies
with the debt-to-capital ratio [D/(D+ E)] as given in the Table below. The current 12-
month Libor is 4.5 percent. The market risk premium is 4 percent, and unleveraged beta
is 0.9. The risk-free rate is 4.25 percent. The company’s tax rate is 36 percent.
Debt to
Capital less 0.40 to 0.50 to 0.60 to 0.70 to 0.80 to 0.90 or
Ratio than 0.4 0.49 0.59 0.69 0.79 0.89 higher
Spread 200 300 400 600 800 1000 1200
 Determine the WACC for 10 percent intervals of the debt-to- capital ratio (i.e., 0.1, 0.2,
etc.) based on the information given in the Table.
 Recommend a target capital structure based on 10 percent intervals of the debt-to- Capital
ratio, recommend a target capital structure.

33. XYZ Ltd. has the following book value capital structure
Equity Capital (in shares of ` 10 each, fully paid up- at par) – Rs. 15 crores
11% Preference Capital (in shares of ` 100 each, fully paid up- at par) – Rs.1 crore
Retained Earnings- Rs. 20 crores
13.5% Debentures (of ` 100 each)- Rs. 10 crores
15% Term Loans- Rs. 12.5 crores
The next expected dividend on equity shares per share is ` 3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is ` 40. Preference stock,
redeemable after ten years, is currently selling at ` 75 per share. Debentures, redeemable
after six years, are selling at ` 80 per debenture. The Income tax rate for the company is
40%.
a. Calculate the current weighted average cost of capital using book value proportions;
and market value proportions.
b. Define the weighted marginal cost of capital schedule for the company, if it raises
` 10 crores next year, given the following information:
 the amount will be raised by equity and debt in equal proportions;
 the company expects to retain ` 1.5 crores earnings next year;
 the additional issue of equity shares will result in the net price per share being fixed at `
32;
 the debt capital raised by way of term loans will cost 15% for the first ` 2.5 crores and
16% for the next ` 2.5 crores.

34. Abc ltd. has the following structure

The debentures are redeemable after 3 years and are quoting at Rs. 981.05 per debenture.
Tax rate is 35%. The current market price per equity share is Rs. 60. The prevailing default
risk free rate is 5.5%. The average market risk premium is 8%. The beta is 1.1875. The
preference stock is redeemable after 5 years and currently is selling at Rs 98.15 per share.
Calculate:
WACC using market value weights
MCOC if firm raises Rs. 750 million for a new project. The firm plans to have debt of
20% in the new capital. The beta for the new project is 1.4375. The debt capital will be
raised through term loans. It will carry interest rate of 9.5% for the first Rs. 100 million
and 10% for the next 50 million.
Equity Share capital Rs. 1500 million

Reserves & Surplus Rs. 2250 million

10.5% Preference share capital of Rs. 100 each Rs. 100 million

9.5% Debentures of Rs. 1000 each Rs. 1500 million

8.5% Term loan Rs. 500 million

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