Q.1 The director of capital budgeting for XYZ, Inc.

manufacturers of playground equipment, is

considering a plan to expand production facilities in order to meet an increase in demand. He estimates
that this expansion will produce a rate of return of 12%. The firm’s target capital structure calls for a debt
ratio of 18%. See-Saw currently has a bond issue outstanding which will mature in 22 years and has a 4%
annual coupon rate. The bonds are currently selling for $527.88. The firm has maintained a constant
growth rate of 6%. See-Saw’s most recent dividend is $3.85 and its current stock price is $43.00. Its tax
rate is 40%. What is the firm's Weighted Average Cost of Capital (WACC)? (Assume that there is no
preferred stock outstanding.)

Q.2 The director of capital budgeting for XYZ, Inc. manufacturers of playground equipment, is
considering a plan to expand production facilities in order to meet an increase in demand. He estimates
that this expansion will produce a rate of return of 21%. The firm’s target capital structure calls for a debt
ratio of 32%. See-Saw currently has a bond issue outstanding which will mature in 19 years and has a
20% annual coupon rate. The bonds are currently selling for $1,984.51. The firm has maintained a
constant growth rate of 10%. See-Saw’s most recent dividend is $3.21 and its current stock price is
$16.00. Its tax rate is 40%. What is the firm's Weighted Average Cost of Capital (WACC)? (Assume that
there is no preferred stock outstanding.)

Q.3 The director of capital budgeting for XYZ, Inc. manufacturers of playground equipment, is
considering a plan to expand production facilities in order to meet an increase in demand. He estimates
that this expansion will produce a rate of return of 13%. The firm’s target capital structure calls for a debt
ratio of 7%. See-Saw currently has a bond issue outstanding which will mature in 29 years and has a 1%
annual coupon rate. The bonds are currently selling for $218.91. The firm has maintained a constant
growth rate of 9%. See-Saw’s most recent dividend is $2.79 and its current stock price is $30.00. Its tax
rate is 40%. What is the firm's Weighted Average Cost of Capital (WACC)? (Assume that there is no
preferred stock outstanding.)

Q.4 A company's bond has a coupon rate of 9.00% and has 19 years remaining until maturity. The
company's bonds pay interest semi-annually. Due to a cash flow problem, the company will be unable to
pay the interest payments for periods 8, 9, and 10. These missed payments will be repaid in one lump sum
when the bond matures, without interest. If the Yield to Maturity (YTM) on similar bonds is 8%, what is
the intrinsic value of this bond?

Q.5 Suppose a company uses only debt and internal equity to finance its capital budget and uses CAPM to
compute its cost of equity. Company estimates that its WACC is 12%. The capital structure is 75% debt
and 25% internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%. Risk free rate is rRF = 6%
and market risk premium (rm - rRF ) = 8%: What is the beta of the company?

Q.6 A company finances its operations with 50 percent debt and 50 percent equity. Its net income is I =
$30 million and it has a dividend payout ratio of x = 20%. Its capital budget is B = $40 million this year.
The interest rate on company’s debt is rd = 10% and the company’s tax rate is T = 40%.
The company’s common stock trades at P0 = $66 per share, and its current dividend of D0 = $4 per share
is expected to grow at a constant rate of g = 10% a year.
The flotation cost of external equity, if issued, is F = 5% of the dollar amount issued.

a) Will the company have to issue external equity?

b) What is the company’s WACC?
Q.7 A company finances its operations with 40 percent debt and 60 percent equity. Its net income is I =
$16 million and it has a dividend payout ratio of x = 25%. Its capital budget is B = $15 million this year.
The annual yield on the company’s debt is rd = 10% and the company’s tax rate is T = 30%. The
company’s common stock trades at P0 = $55 per share, and its current dividend of D0 = $5 per share is
expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if it is issued,
is F = 5% of the dollar amount issued. What is the company’s WACC?
Q.8 Suppose a company uses only debt and internal equity to finance its capital budget and uses CAPM to
compute its cost of equity. Company estimates that its WACC is 12%. The capital structure is 75% debt
and 25% internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%. Risk free rate is r R F = 6%
and market risk premium (r m — r RF) = 8%. What is the beta of the company?
Q.9 A company finances its operations with 50 percent debt and 50 percent equity. Its net income is I =
$30 million and it has a dividend payout ratio of x = 20%. Its capital budget is B = $40 million this year.
The interest rate on company’s debt is rd = 10% and the company’s tax rate is T = 40%.
The company’s common stock trades at P 0 = $66 per share, and its current dividend of D0 = $4 per share
is expected to grow at a constant rate of g = 10% a year.
The flotation cost of external equity, if issued, is F = 5% of the dollar amount issued.
a) Will the company have to issue external equity?
b) What is the company’s WACC?
Q.10 A company finances its operations with 40 percent debt and 60 percent equity. Its net income is I =
$16 million and it has a dividend payout ratio of x = 25%. Its capital budget is B = $15 million this year.
The annual yield on the company’s debt is r d = 10% and the company’s tax rate is T = 30%.
The company’s common stock trades at Po = $55 per share, and its current dividend of D 0 = $5 per share
is expected to grow at a constant rate of g = 10% a year. The flotation cost of external equity, if it is
issued, is F = 5% of the dollar amount issued. What is the company’s WACC?
Now the company is planning to expand its operations. The managing director has proposed two
investments alternative Project X and Y. Below are the cash flows for two mutually exclusive projects.
year CFX CFY
0 (5 m) (5 m)
1 2.085m 0
2 2.085m 0
3 2.085m 0
4 2.085m 9.677m
On the basis of MIRR, evaluate which project is more feasible?

Q.11 Delta, Inc. has a stock price of $50. In the fiscal year just ended, dividends were $2.00. Earnings per
share and dividends are expected to increase at an annual rate of 8 percent. The risk-free rate is 4 percent,
the market risk premium is 6.4 percent and the beta on Delta’s stock is 1.25. Delta’s target capital
structure is 40% debt and 60% common equity. Delta’s tax rate is 40 percent. New common stock can be
sold to net $40 per share after flotation costs. Delta can sell bonds that mature in 25 years with a par value
of $1,000 and an 8% coupon rate paid annually for $960.
a. Calculate the before-tax interest rate on new debt financing.
b. Calculate the after-tax cost of debt financing.
c. Calculate the required return on the firm’s stock using CAPM.
d. Calculate the required return on the firm’s stock using the discounted cash flow approach.
e. Calculate the cost of financing from the sale of common stock.
f. Calculate the WACC if equity financing is from retained earnings.
g. Calculate the WACC if equity financing is from the sale of common stock.
Q.12 A firm is considering a new project which would be similar in terms of risk to its existing projects.
The firm needs a discount rate for evaluation purposes. The firm has enough cash on hand to provide the
necessary equity financing for the project. Also, the firm:

- has 1,000,000 common shares outstanding

- current price $11.25 per share
- next year’s dividend expected to be $1 per share
- firm estimates dividends will grow at 5% per year after that
- flotation costs for new shares would be $0.10 per share
- has 150,000 preferred shares outstanding
- current price is $9.50 per share
- dividend is $0.95 per share
- if new preferred are issued, they must be sold at 5% less than the current market
price (to ensure they sell) and involve direct flotation costs of $0.25 per share
- has a total of $10,000,000 (par value) in debt outstanding. The debt is in the form of bonds
with 10 years left to maturity. They pay annual coupons at a coupon rate of 11.3%. Currently,
the bonds sell at 106% of par value. Flotation costs for new bonds would equal 6% of par
value.
The firm’s tax rate is 40%. What is the appropriate discount rate for the new project?

Q.13 Given the following information, what is the WACC for the following firm?

Debt: 9,000 bonds with a par value of $1,000 and a quoted price of 1126.5. The bonds have
coupon rate of 7 percent and 28 years to maturity.
Preferred Stock: 20,000 shares of 3.5 percent preferred selling at a price of $65.
Common Stock: 400,000 shares of stock selling at a market price of $48. The beta of the stock is 0.9. The
stock just paid a dividend of $2.10 per share and the dividends are expected to grow at 6
percent per year indefinitely.
Market: The expected return on the market is 14 percent and the risk-free rate is 3.5 percent. The
company is in the 38 percent tax bracket.
Q.14 The Perkins Company has employed you to analyze a capital project. It has given you the following
information:

Bond Coupon Rate Price Quote Maturity Number of Bonds Outstanding

1 6.75 955 22 35,000
2 7.25 1100 20 45,000
The bonds make semiannual interest payments and the marginal tax rate is 40 percent. Perkins expects
the next dividend (D1) to be $0.45 and its common stock is currently selling for $5.625 per share. The
expected growth rate in earnings and dividends is a constant 5%. Perkins has a beta of 1.3, the risk-free
rate is 3 percent, and the expected market return is 12.5 percent. Perkins has 25,000,000 shares of
common stock outstanding.

To complete the analysis, the NPV and IRR need to be calculated the project. The initial investment is
$22.2 million. The net cash flows are $6 million for years one through four and $8 million for year five.
Should Perkins accept this project?
A.1 Find the Cost of Debt.

1. Using the TVM functions on your calculator: N=22, I=???, PV=$527.88,

PMT=4%*1000=$40.00, FV=1000. Solve for the Yield to Maturity (I). ANSWER: 0.0900

Find the Cost of Equity.

1. There is no preferred stock, so this is ignored in your calculations.

2. Using the GGM formula for stock valuation: Ke=D1/P0 + g => Ke = (3.85*(1+0.06))/43 +
0.06. ANSWER: 0.1549

Step Two:
Find the weights of equity and debt

1. The debt ratio was given in the problem, so the weight of debt was given as 18%.
Therefore, the weight of equity must be 82%.

Step Three:
Use the WACC formula. WACC = W e*Ke + Wd*Kd*(1-taxrate)

1. WACC = 82% * 0.154906976744 + 18% * 0.09 * (1-40%)

2. ANSWER: 0.1367

A.2 Step One:

Find the Cost of Debt.

1. Using the TVM functions on your calculator: N=19, I=???, PV=$1,984.51,

PMT=20%*1000=$200.00, FV=1000. Solve for the Yield to Maturity (I). ANSWER:
0.0900

Find the Cost of Equity.

1. There is no preferred stock, so this is ignored in your calculations.

2. Using the GGM formula for stock valuation: Ke=D1/P0 + g => Ke = (3.21*(1+0.1))/16 +
0.1. ANSWER: 0.3207

Step Two:
Find the weights of equity and debt

1. The debt ratio was given in the problem, so the weight of debt was given as 32%.
Therefore, the weight of equity must be 68%.

Step Three:
Use the WACC formula. WACC = W e*Ke + Wd*Kd*(1-taxrate)

1. WACC = 68% * 0.3206875 + 32% * 0.09 * (1-40%)

2. ANSWER: 0.2353
A.3 Step One:
Find the Cost of Debt.

1. Using the TVM functions on your calculator: N=29, I=???, PV=$218.91,

PMT=1%*1000=$10.00, FV=1000. Solve for the Yield to Maturity (I).

ANSWER: 0.0800

Find the Cost of Equity.

1. There is no preferred stock, so this is ignored in your calculations.

2. Using the GGM formula for stock valuation: Ke=D1/P0 + g => Ke = (2.79*(1+0.09))/30 +
0.09. ANSWER: 0.1914

Step Two:
Find the weights of equity and debt

1. The debt ratio was given in the problem, so the weight of debt was given as 7%.
Therefore, the weight of equity must be 93%.

Step Three:
Use the WACC formula. WACC = W e*Ke + Wd*Kd*(1-taxrate)

1. WACC = 93% * 0.19137 + 7% * 0.08 * (1-40%)

2. ANSWER: 0.1813

A.4 PROBLEM SOLUTION:

ANSWER DETAILS

Methodology:
There are four simple steps to solving this problem.

1. Step One: Find the present value of the bond IGNORING the missing payments. This will
serve as the baseline value. We will adjust this value for the missing payments.
2. Step Two: Find the present value of the three missing payments.
3. Step Three: Find the Present Value of the payment received at maturity to replace the
missing three payments at time 8, 9, and 10.
4. Step Four: Adjust the Present value in Step One for the impacts of the items in Steps
Two and Three.

Step One:
Find the present value of the bond IGNORING the missing payments.

1. PV of Bond: N=38, I=8 / 2, PV=?, PMT=45, FV=1000

2. ANSWER: $1,096.84

Step Two:
Find the present value of the three missing payments.
 1. PV of PMT at time 8: N=8, I=8 / 2, PV=?, PMT=0, FV=45
2. PV of PMT at time 9: N=9, I=8 / 2, PV=?, PMT=0, FV=45
3. PV of PMT at time 10: N=10, I=8 / 2, PV=?, PMT=0, FV=45
4. ANSWER: $94.90

Step Three:
Find the Present Value of the payment received at maturity to replace the missing three
payments at time 8, 9, and 10.

1. PV of missing payments repaid at maturity: N=38, I=8 / 2, PV=?, PMT=0, FV=135 (3

Missed payments = $45.00*3)
2. ANSWER: $30.41

Step Four:
Adjust the Present value in Step One for the impacts of the items in Steps Two and Three.

1. Total PV = Total PV if no missing payments (Step One) - PV of missing payments (Step

Two) + PV of missed payments paid at maturity (Step Three)
2. Total PV = $1,096.84 (Step One) - $94.90 (Step Two) + $30.41 (Step Three)
3. ANSWER: $1,032.36

ANSWER CALCULATOR:
N= 38

I= 0.04

PV = -1096.84

PMT = 45

FV = 1000

m= 1

Ans:5 WACC = wdrd(1 􀀀 T) + were

0:12 = 0:75(0:125)(1 􀀀 0:20) + 0:25re
0:12 = 0:075 + 0:25re
re = 18%
re = 18% = rRF + _(rm 􀀀 rRF )
18% = 6% + _(8%)
_beta = 1:5

Ans: 6a weB = 0:50(40M) = 20M

I(1 􀀀 x) = $30(1 􀀀 0:2) = 24M
Since I(1 􀀀 x) > weB =)Internal Equity

b.
Ans 6:
Solution 12:

Market value of common = 11.25(1000000) = $11,250,000

Market value of preferred = 9.50(150000) = $1,425,000

Market value of debt = 10000000(1.06) = $10,600,000

Total value of firm = $23,275,000

Cost of common:

(Note: floatation costs ignored for common equity because cash on hand is enough to finance the project.)

Div 1
r g
P
1
  0.05
11.25
 0.1389

Cost of preferred:
 Div
r
net P
0.95

9.50(1  0.05)  0.25
 0.1083

Cost of debt:

Net price = 106% - 6% = 100% of par value

Net price = par

Therefore, cost of debt = coupon rate

r = 11.3%

Therefore:

 11250000   1425000   10600000 

WACC   0.1389   0.1083   0.1131  0.4
 23275000   23275000   23275000 
 0.1046
 10.46%

Solution 13:

1. Component Costs

Debt

70    
1,126.50   PVIFA   1,000 PVIF 
2   28 2 , YTM
2



  28 2 , YTM
2



N (2)(28) = 56
Cpt I 3.028% = YTM/2 → YTM = 6.06%
PV -$1,126.50
Pmt 35
FV 1,000

Preferred Stock

D1 3.50
kp = = = .0538 or 5.38 %
P0 65

Equity:
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm.

ke = Rf + [E(RM) – Rf] = 3.5 + 0.9[14 – 3.5] = 12.95%

Advantages of the CAPM

Explicitly adjusts for systematic risk

Applicable to all companies, as long as we can compute beta

Disadvantages of the CAPM

Have to estimate the expected market risk premium, which does vary over time

Have to estimate beta, which also varies over time

We are relying on the past to predict the future, which is not always reliable

D1 2.10(1.06)
ke = +g= + .06 = .1064 or 10.64%
P0 48

Advantage of Gordon Growth Model

Easy to understand and use

Disadvantages of Gordon Growth Model

Only applicable to companies currently paying dividends

Not applicable if dividends aren’t growing at a reasonably constant rate

Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1%

Does not explicitly consider risk

12.95%  10.64%
ke = = 11.80%
2

2. Component Weights
Debt: (9,000)($1,126.50) = $10,138,500 wd = 0.331
PS: (20,000)($65) = $1,300,000 wp = 0.042
E: (400,000)($48) = $19,200,000 we = 0.627
$30,638,500

3. WACC
WACC = wDRD(1-TC) + wPRP + wERE

WACC = (0.331)(6.06%)(1 – 0.38) + (0.042)(5.38) + (0.627)(11.80) = 8.86%

Solution 14:

1. Component Costs

Debt

Bond 1

67.5    
955.00   PVIFA YTM   1,000 PVIF YTM 
2  2  22 ,
2



 2  22 ,
2



N (2)(22) = 44
Cpt I 3.58% = YTM/2 → YTM = 7.16%
PV -$955.00
Pmt 33.75
FV 1,000

Bond 2

72.5    
1,100.00   PVIFA YTM   1,000 PVIF YTM 
2  2  20 ,
2



 2  20 ,
2



N (2)(20) = 40
Cpt I 3.18% = YTM/2 → YTM = 6.36%
PV -$1,100.00
Pmt 36.25
FV 1,000
Weighted cost of debt

Bond 1: (35,000)($955.00) = $33,425,000 wd1 = 0.4031

Bond 2: (45,000)($1,100.00) = $49,500,000 wd2 = 0.5969
$82,925,000
RD = wD1RD1 + wD2RD2

RD = (0.4031)(7.16%) + (0.5969)(6.36%) = 6.68%

Equity

ke = Rf + [E(RM) – Rf] = 3.0 + 1.3[12.5 – 3.0] = 15.35%

 D1 0.45
ke = +g= + .05 = .1300 or 13.00%
P0 5.625

15.35%  13.00%
ke = = 14.175%
2

2. Component Weights
Debt: $82,925,000 wd = 0.3709
E: (25,000,000)($5.625) = $140,625,000 we = 0.6291
$223,550,000

3. WACC
WACC = wDRD(1-TC) + wPRP + wERE

WACC = (0.3709)(6.68%)(1 – 0.40) + (0.6291)(14.175) = 10.404%

CF0 -12.2
CF1 6.0 F1 4
CF2 8.0 F2 1

I 10.404%
Cpt NPV $11.53
Cpt IRR 41.80%