1. What does it mean when people refer to a firm’s “cost of capital?”
2. What are the three components that normally make up a firm’s weighted average cost of capital (WACC)?
3. (calculating the after-tax cost of debt) Suppose your firm can borrow what it needs from a local bank at 4.5% interest. If your firm’s effective tax rate is 40%, what is its after-tax cost of debt?
4. (calculating the cost of preferred stock) Suppose your firm wants to finance a project, in part, with 4.0%, $100 par preferred stock which the firm’s investment bankers say can be sold for $60 a share. The investment bankers will charge your firm $1 a share to handle the stock issue. Given these conditions, what is your firm’s cost of preferred stock?
5. (calculating the cost of common stock, or common equity per the dividend growth model approach) Your firm’s common stock is selling for $37.00 a share and it paid a dividend last year to the common stockholders of $1.60. If the growth rate in earnings and dividends for your firm is estimated to be a constant 5% for the foreseeable future, what is your firm’s cost of common equity per the dividend growth model approach?
6. (cost of common stock, or common equity per the CAPM approach) After some research on the Internet, you determine that the risk-free rate (as measured by ten-year treasury bonds) is 2.34%. You also determine that analysts believe the average rate of return on the stock market as a whole is 9.0%. Your firm has a beta of 1.1. Given these conditions, what is your firm’s what is your firm’s cost of common equity per the CAPM approach?
7. (determining the final cost of common equity) Given your answers to questions 5 and 6 above, what is your final estimate of your firm’s cost of common equity?
8. (calculating the WACC) Given your answers to questions 3, 4, and 7 above, what is your estimate of your estimate of your firm’s weighted average cost of capital if it wishes to maintain a capital structure of 40% debt,10% preferred stock, and 50% common equity?
9. What is the WACC normally used for?
End of assignment questions
(see answers to numerical problems below)
Answers to numerical problems:
Question 3: 2.7%
Question 4: 6.78%
Question 5: 9.54%
Question 6: 9.67%
Question 7: 9.60%
Question 8: 6.56%