Questions – Cost of Capital
1. The cost of equity is equal to
a. Expected market return.
b. Rate of return required by stockholders.
c. Cost of retained earnings plus dividends.
2. Using the dividend discount model, what is the cost of equity capital for company A if
the company will pay a dividend of $2.30 next year, has a payout ratio of 30%, a return
of equity (ROE) of 15%, and a stock price of $45?
a. 9.61 %
b. 10.50 %
c. 15.61 %
3. Company X has determined that it could issue $1,000 face value bonds with an 8%
coupon paid semi-annually and a 5-year maturity at $900 per bond. If X’s marginal tax
rate is 38%, its after-tax cost of debt is closest to:
a. 6.2 %
b. 6.4 %
c. 6.6 %
4. Company Y issued a fixed-rate perpetual preferred stock 3 years ago and placed it
privately with institutional investors. The stock was issued at $25 per share with a $1.75
dividend. If the company were to issue preferred stock today, the yield would be 6.5 %.
The stock’s current value is:
a. $25
b. $26.92
c. 37.31
5. A financial analyst at Company Z wants to compute the company’s weighted average
cost of capital (WACC) using the dividend discount model. The analyst has gathered the
following data:
Before-tax cost of new debt 8%
Tax Rate 40%
Target debt-to-equity ratio 0.8033
Stock price $30
Next year’s dividend $1.50
Estimated growth rate 7%
Company Z’s WACC is closest to:
a. 8%
b. 9%
c. 12%
6. Fran McClure, of Alba Advisers, is estimating the cost of capital of Frontier
Corporation as part of her valuation analysis of Frontier. McClure will be using
this estimate, along with projected cash flows from Frontier’s new projects, to
estimate the effect of these new projects on the value of Frontier. McClure has
gathered the following information on Frontier Corporation:
Current Year ($) Forecasted for Next Year ($)
Book value of debt 50 50
Market value of debt 62 63
Book value of equity 55 58
Market value of equity 210 220
a. wd = 0.200 and we = 0.800.
b. wd = 0.185 and we = 0.815.
c. wd = 0.223 and we = 0.777.
7. An analyst gathered the following information about a private company and its publicly
traded competitor:
Comparable Tax Rate (%) Debt/Equity Equity Beta
Companies
Private company 30 1 N/A
Public company 35 0.90 1.75
The estimated equity beta for the private company is closest to:
a. 1.029
b. 1.104
c. 1.877
8. At the time of valuation, the estimated betas for JPMorgan Chase & Co. and the
Boeing Company were 1.50 and 0.80, respectively. The risk-free rate of return was 4.35%,
and the equity risk premium was 8.04%. Based on these data, calculate the required rates
of return for these two stocks using the CAPM.
9. An analyst’s data source shows that Newmont Mining (NEM) has an estimated
beta of –0.2. The risk-free rate of return is 2.5%, and the equity risk premium is
estimated to be 4.5%.
a. Using the CAPM, calculate the required rate of return for investors in NEM.
b. The analyst notes that the current yield to maturity on corporate bonds with
a credit rating similar to NEM is approximately 3.9%. How should this information
affect the analyst’s estimate?
10. Happy Resorts Company currently has 1.2 million common shares 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 an 8% coupon with semi-annual
payments and are priced to yield 13.65%. If Happy issues up to $2.5 mil-
lion of new bonds, the bonds will be priced at par and will have a yield of
13.65%; if it issues bonds beyond $2.5 million, the expected yield on the entire
issuance will be 16%. Happy has learned that it can issue new common stock at
$10 a share. The current risk- free rate of interest is 3%, and the expected market
return is 10%. Happy’s marginal tax rate is 30%. If Happy raises $7.5 million of
new capital while maintaining the same debt- to- equity ratio, its weighted average cost
of capital will be closest to:
a. 14.5%
b. 15.5%
c. 16.5%
