chAP 12 CONTIN

International Exchange has three divisions: A, B, and C. Division A has the least risk and Division C has the most risk. The firm has an aftertax cost of debt of 6.1percent and a cost of equity of 14.3 percent. The firm is financed with 37 percent debt and 63 percent equity. Division A's projects are assigned a discount rate that is 2.2 percent less than the firm's weighted average cost of capital. What is the discount rate applicable to Division A?

Firms WACC .37*6.1+6.3*14.3=2.257+9.009=11.27% Division A's WACC 11.27%-2.2%= 9.07%

The common stock of Mill Stones has a beta that is 8 percent greater than the overall market beta. Currently, the market risk premium is 7.65 percent while the U.S. Treasury bill is yielding 4.3 percent. What is the cost of equity for this firm?

Market beta is always 1 Beta of common stock = 1.08 (since it is 8% more) Cost of equity = risk free rate + beta*market risk premium = 4.3% + 1.08 * 7.65% = 12.56%

Stock in ABC Enterprises has a beta of 1.28. The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent. ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely. If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity?

cost of equity = D*(1+g)/P + g = 1.62*1.02/38 + .02 = .0435 + .02 = 6.35% Cost of equity = risk free rate + beta * market risk premium = 3.6 + 1.28*7.4 = 13.07% Using both the methods and taking the average = (6.35 + 13.07)/2 = 9.71%

Assume a firm has a beta of 1.2. All else held constant, the cost of equity for this firm will increase if the:

decrease in the risk free rate, if risk free rate decreases market premium will increase and there by cost of equity will increase

The 7.5 percent preferred stock of Rock Bottom Floors is selling for $84 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

dividend = 7.5% * 100 = 7.5 cost of preferred stock = dividend/price = 7.5/84 = 8.93%

Bermuda Cruises issues only common stock and coupon bonds. The firm has a debt-equity ratio of .45. The cost of equity is 17.6 percent and the pretax cost of debt is 8.9 percent. What is the capital structure weight of the firm's equity if the firm's tax rate is 35 percent?

Debt Equity ratio = Debt / Equity = 0.45 It means that If Equity is 1 debt is 0.45. Hence total of debt + Equity = 0.45 + 1 = 1.45 Hence capital structure weight of the firm's equity = Equity / Total debt plus equity = 1 / 1.45 = 68.97%

The 6.5 percent preferred stock of Home Town Brewers is selling for $42 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100?

PREFERED DIVIDEND = $100 * 6.5% = $6.50 CURRENT PRICE OF DIVIDEND = DIVIDEND / COST OF PREFERD STOCK $42 = $6.50 / COST OF PREFERD STOCK COST OF PREFERD STOCK = $6.50 / $42 COST OF PREFERD STOCK = 0.1548 OR 15.48%

Given the following information for Electric Transport, find the WACC. Assume the company's tax rate is 35 percent. Debt:8,100, 6.9 percent coupon bonds outstanding. $1,000 par value, 17 years to maturity, selling for 101 percent of par, the bonds make semiannual payments. Common stock: 175,000 shares outstanding, selling for $77 per share, beta is 1.32. Preferred stock:9,000 shares of $7.50 preferred stock outstanding, currently selling for $73 per share. Market: 7.9 percent market risk premium and 3.6 percent risk-free rate.

The weighted average cost of capital is calculated using the below formula: WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke Where: Wd= Percentage of debt in the capital structure. Kd= The before tax cost of debt Wps= Percentage of preferred stock in the capital structure Kps=Cost of preferred stock We=Percentage of equity in the capital structure Ke= The cost of common equity. T= Tax rate The cost of debt is calculated by computing the yield to maturity. Given: Future Value (FV)= $1,000 Present Value (PV)= $1,010. Coupon rate= 6.9%/2= 3.45% Coupon payment= 0.0345*1,000= $34.50 Time period= 17 years*2= 34 semi-annual periods The yield to maturity is calculated with the help of a financial calculator by inputting the below: FV= 1,000; PV= -1010; PMT= 34.50; N=34 Press CPT and I/Y to compute the yield to maturity. The yield to maturity is 3.40*2= 6.80% After tax cost of debt= 6.80%(1-0.35)= 4.42% The cost of equity is calculated using the capital asset pricing model. The formula for calculating the capital asset pricing model is given below: Ke=Rf+[E(Rm)-Rf] Where: Rf=risk-free rate of return which is the yield on default free debt like treasury notes Rm=expected rate of return on the market. B= Beta of the company Given: Risk free rate= 3.6% Market premium= 7.9% Beta= 1.32 Cost of Equity: Ke= 3.6%+1.32*7.9% = 3.6%+ 10.43%= 14.03%. Cost of preferred stock: Kps=Dps/P Where: Kps= Cost of preferred stock Dps=preferred dividend P= Market price of preferred stock Preference shares do not have any tax benefits like debt. Given: Preference dividend= $7.50 Stock price= $73 Rate of return on preference stock= $7.50/73= 0.1027= 10.27%. Debt in the capital structure: Market value of debt: 8100*$1,010= $8,181,000. Equity in the capital structure: Market value of equity: 175,000*$77= $13,475,000. Preference stock in the capital structure: Market value of preference shares: 9,000*$73= $657,000. Total Capital: $8,181,000+ $13,475,000+ $657,000= 22,313,000. Percentage of debt in the capital structure: $8,181,000/ 22,313,000= 37% Percentage of equity in the capital structure: $13,475,000/ 22,313,000= 60% Percentage of preference stock in the capital structure= $657,000/ 22,313,000= 3% WACC= 0.37*4.42% + 0.60*14.03%+ 0.03*10.27%. = 1.64%+ 8.42%+ 0.31= 10.37%. Therefore, the WACC is 10.37%.

Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $19.4 million. The bonds mature in 6.5 years and pay semiannual interest payments of $35 each. What is the firm's pretax cost of debt?

YTM= (Interest-to be taken yearly+(Face value-market value)/n)/(face value+market value)/20 .0757517

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

automatically gives preferential treatment in the allocation of funds to its riskiest division