Topic 5 & 6

1. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently, the
yield to maturity (YTM) on these bonds is 14%. If the firm’s tax rate is 40%, what is the
company’s after-tax cost of debt?
A. 5.6%.
B. 8.4%.
C. 14.0%.

2. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value.
B. [(1 – tax rate) times the preferred stock dividend] divided by price.
C. the preferred stock dividend divided by its market price.

3. A company’s $100, 8% preferred is currently selling for $85. What is the company’s cost
of preferred equity?
A. 8.0%.
B. 9.4%.
C. 10.8%.

4. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of
equity if the long-term growth in dividends is projected to be 8%?
A. 15%.
B. 16%.
C. 18%.
5. An analyst gathered the following data about a company:
Capital structure Required rate of return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock
Assuming a 40% tax rate, what after-tax rate of return must the company earn on its
investments?
A. 13.0%.
B. 14.2%.
C. 8.0%.
6. The company stock beta is 1.1. Risk-free rate is 10%, and market risk premium is 7%. The
company’s cost of equity using the capital asset pricing model (CAPM) approach is:
A. 17.0%.
B. 17.7%.
C. 17.9%.

7. What happens to a company’s weighted average cost of capital (WACC) if the firm’s
corporate tax rate increases and if the Federal Reserve causes an increase in the risk-free rate,
respectively? (Consider the events independently and assume a beta of less than one.)
Tax rate increase Increase in risk-free rate
A. Decrease WACC Increase WACC
B. Decrease WACC Decrease WACC
C. Increase WACC Increase WACC
8. Using the dividend discount model, what is the cost of equity capital for Company A if it
will pay a dividend of $2.30 next year, has a payout ratio of 30%, ROE=15% and a stock
price of $45.
A. 9.61%
B. 10.5%
C. 15.61%

9. An analyst gathered the following information about a private company and its public
traded competitor.
Companies Tax rate (%) Debt/Equity Equity beta
Private company 30 1 ???
Public company 35 0.9 1.75
The estimated equity beta for the private company is closest to:
A. 1.029
B. 1.104
C. 1.877
10. What is the intrinsic value of a company’s stock if dividends are expected to grow
constantly at 5%, the most recent dividend was $1, and investors’ required rate of return for
this stock is 10%?
A. $20.00.
B. $21.00.
C. $22.05.

11. An analyst feels that Brown Company’s earnings and dividends will grow at 25% for two
years, after which growth will fall to a constant rate of 6%. If the projected discount rate is
10%, and Brown’s most recently paid dividend was $1, the value of Brown’s stock using the
multistage dividend discount model is closest to:
A. $31.25.
B. $33.54.
C. $36.65.

12. 11.11
Calculating the Cost of Capital.
Whirlpool manufactures and sells home appliances under various brand names. IBM
develops and manufactures computer hardware and offers related technology services. Target
operates a chain of general merchandise discount retail stores. The data in the following table
apply to these companies (dollar amounts in millions). For each firm, assume that the market
value of the debt equals its book value.
Little House is a manufacturer of home appliances; Smart Compact develops and
manufactures computer hardware and related technology services; Perfect Market operates a
chain of food stores with low price. Assume that the market value of debt equals to book
value of debt of each firm.
Exhibit 3.2 Summary of financial information of three companies (USD in million)
Little House Smart Compact Perfect Mart
Total assets 14,350 110,150 46,250
Interest bearing debt 2,650 34,245 20,115
Average pretax borrowing cost 7% 5.1% 5.6%
Common equity
Book value 3,750 14,560 14,730
Market value 2,990 102,750 25,550
Income tax rate 35% 35% 35%
Market equity beta 2.25 0.85 1.35

a. Assume that the intermediate-term yields on U.S. government Treasury securities are
5.0%; the required rate of return of the market is 12%. Compute the cost of equity
capital for each of the three companies.
b. Compute the weighted-average cost of capital for each of the three companies.
c. Compute the unlevered market (asset) beta for each of the three companies.

REQUIRED
a. Assume that the intermediate-term yields on U.S. government Treasury securities are
3.5%. Assume that the market risk premium is 5.0%. Compute the cost of equity capital for
each of the three companies.
b. Compute the weighted-average cost of capital for each of the three companies.
c. Compute the unlevered market (asset) beta for each of the three companies.
d. Assume that each company is a candidate for a potential leveraged buyout. The buyers
intend to implement a capital structure that has 75% debt (with a pretax borrowing cost of
8.0%) and 25% common equity. Project the weighted-average cost of capital for each
company based on the new capital structure. To what extent do these revised weighted
average costs of capital differ from those computed in Requirement b?
13. (11.12) Calculation of Dividends-Based Value.
Royal Dutch Shell (Shell) is a petroleum and petrochemicals company. It engages primarily
in the exploration, production, and sale of crude oil and natural gas and the manufacture,
transportation, and sale of petroleum and petrochemical products. The company operates in
approximately 200 countries in North America, Europe, Asia-Pacific, Africa, South America,
and the Middle East. Assume that during the past three years (Year -2, -1, and 0), Shell
generated the following total dividends to common equity shareholders (in USD millions):

Analysts project 5% growth in earnings over the next five years. Assuming concurrent 5%
growth in dividends, the following table provides the amounts that analysts project for Shell’s
total dividends for each of the next five years. In Year +6, total dividends are projected for
Shell assuming that its income statement and balance sheet will grow at a long-term growth
rate of 3%.

At the end of Year 0, Shell had a market beta of 0.71. At that time, yields on intermediate
term U.S.Treasuries were 3.5%. Assume that the market required a 5.0% risk premium.
Suppose Shell had 6,241 million shares outstanding at the beginning of Year +1 that traded at
a share price of $24.87.
REQUIRED
a. Calculate the required rate of return on equity for Shell as of the beginning of Year +1.
b. Calculate the sum of the present value of total dividends for Years +1 through +5.
c. Calculate the continuing value of Shell at the start of Year .6 using the perpetuity-with-
growth-model with Year +6 total dividends. Also compute the present value of continuing
value as of the beginning of Year +1.
d. Compute the total present value of dividends for Shell as of the beginning of Year +1.
Remember to adjust the present value for midyear discounting.
e. Compute the value per share of Shell as of the beginning of Year +1.
f. Given the share price at the start of Year +1, do Shell shares appear underpriced,
overpriced,
or correctly priced?