8. The Wall Company has 142,500 shares of common stock

8. The Wall Company has 142,500 shares of common stock outstanding that are currently selling
at $28.63. It has 4,530 bonds outstanding that won’t mature for 20 years. They were issued at a par
value of $1,000 paying a coupon rate of 6%. Comparable bonds now yield 9%. Wall’s $100 par value
preferred stock was issued at 8% and is now yielding 11%; 7,500 shares are outstanding. Develop
Wall’s market value based capital structure.
Preferred 545,475 6.9%
Equity 4,079,775 51.6%
Total Capital $7,904,744 100.0%
9. The market price of Albertson Ltd.’s common stock is $5.50, and 100,000 shares are
outstanding. The firm’s books show common equity accounts totaling $400,000. There are 5,000
preferred shares outstanding that originally sold for their par value of $50, pay an annual dividend of $3,
and are currently selling to yield an 8% return. Also, 200 bonds outstanding that were issued five years
ago at their $1,000 face values for 30-year terms pay a coupon rate of 7%, and are currently selling to
yield 10%. Develop Albertson’s capital structure based on both book and market values.

Cost of Debt: Example 13-3 (page 567)
10. Asbury Corp. issued 30-year bonds 11 years ago with a coupon rate of 9.5%. Those bonds are
now selling to yield 7%. The firm also issued some 20-year bonds two years ago with an 8%
coupon rate. The two bond issues are rated equally by Standard and Poors and Moody’s.
Asbury’s marginal tax rate is 38%.
The Cost of Capital
a. What is Asbury’s after-tax cost of debt?
b. What is the current selling price of the 20-year bonds?
11. The Dentite Corporation’s bonds are currently selling to yield new buyers a 12% return on their
investment. Dentite’s marginal tax rate including both federal and state taxes is 38%. What is the
firm’s cost of debt?
12. Kleig Inc.’s bonds are selling to yield 9%. The firm plans to sell new bonds to the general
public and will therefore incur flotation costs of 6%. The company’s marginal tax rate is 42%.
a. What is Kleig’s cost of debt with respect to the new bonds? (Hint: Adjust the cost of debt formula to
include flotation costs.)
b. Suppose Kleig also borrows directly from a bank at 12%.
1. What is its cost of debt with respect to such bank loans? (Hint: Would bank loans be subject to
flotation costs?)
2. If total borrowing is 60% through bonds and 40% from the bank, what is Kleig’s overall cost of
debt? (Hint: Think weighted average.)
Cost of Preferred Stock: Example 13-4 (page 568)
13. Harris Inc.’s preferred stock was issued five years ago to yield 9%. Investors buying those
shares on the secondary market today are getting a 14% return. Harris generally pays flotation costs of
12% on new securities issues. What is Harris’s cost of preferred financing?
14. Fuller, Inc. issued $100, 8% preferred stock five years ago. It is currently selling for $84.50.
Assuming Fuller has to pay floatation costs of 10%, what is Fuller’s cost of preferred stock?
15. A few years ago Hendersen Corp issued preferred stock paying 8% of its par value of $50. The
issue is currently selling for $38. Preferred stock flotation costs are 15% of the proceeds of the sale.
What is Hendersen’s cost of preferred stock?
16. New buyers of Simmonds Inc. stock expect a return of about 22%. The firm pays flotation
costs of 9% when it issues new securities. What is Simmonds’ cost of equity (Hint: This problem is
very simple since we don’t have to estimate the investors’ return.)
a. From retained earnings?
b. From new stock?
Cost of Retained Earnings – Constant Growth (Gordon) Model: Example 13-6 (page 570)
17. Klints Inc. paid an annual dividend of $1.45 last year. The firm’s stock sells for $29.50 per share,
and the company is expected to grow at about 4% per year into the foreseeable future. Estimate Klints’
cost of retained earnings.
Chapter 13
Cost of RE and New Stock: Examples 13-6 and 13-8 (pages 570 and 572)
18. The Pepperpot Company’s stock is selling for $52. Its last dividend was $4.50, and the firm is
expected to grow at 7% indefinitely. Flotation costs associated with the sale of common stock are 10%
of the proceeds raised. Estimate Pepperpot’s cost of equity from retained earnings and from the sale of
new stock.
Cost of Retained Earnings – SML: Example 13-5 (page 570)
19. The Longlife Insurance Company has a beta of .8. The average stock currently returns 15% and
short-term treasury bills are offering 6%. Estimate Longlife’s cost of retained earnings.
Cost of Retained Earnings – Risk Premium: Example 13-7 (page 571)
20. The Longlife Insurance Company of the preceding problem has several bonds outstanding that
are currently selling to yield 9%. What does this imply about the cost of the firm’s equity?
21. Hammell Industries has been using 10% as its cost of retained earnings for a number of years.
Management has decided to revisit this decision based on recent changes in financial markets. An
average stock is currently earning 8%, treasury bills yield 3.5%, and shares of Hammell’s stock are
selling for $29.44. The firm just paid a dividend of $1.50, and anticipates growing at 5% for the
foreseeable future. Hammell’s CFO recently asked an investment banker about issuing bonds and was
told the market was demanding a 6.5% coupon rate on similar issues. Hammell stock has a beta of 1.4.
Recommend a cost of retained earnings for Hammell.
22. Suppose Hammell of the previous problem needs to issue new stock to raise additional equity
capital. What is its cost of new equity if and flotation costs are 12%?
MCC: Example 13-9 (page 573)
23. Whitley Motors Inc. has the following capital.
Debt: The firm issued 900, 25 year bonds five years ago which were sold at a par value of $1,000. The
bonds carry a coupon rate of 7%, but are currently selling to yield new buyers 10%.
Preferred Stock:3,500 shares of 8% preferred were sold 12 years ago at a par value of $50. They’re
now priced to yield 11%.
Equity: The firm got started with the sale of 10,000 shares of common stock at $100 per share. Since
that time earnings of $800,000 have been retained. The stock is now selling for $89. Whitley’s
business plan for next year projects net income of $300,000, half of which will be retained.
The firm’s marginal tax rate is 38% including federal and state obligations. It pays flotation costs of 8%
on all new stock issues. Whitely is expected to grow at a rate of 3.5% indefinitely and recently paid an
annual dividend of $4.00.
The Cost of Capital
Develop Whitley’s WACC before and after the retained earnings break and indicate how much capital
will have been raised when the break occurs.
24. The Longenes Company uses a target capital structure when calculating the cost of capital. The
target structure and current component costs based on market conditions follow.
Component Mix Cost*
Debt 25% 8%
Preferred Stock 10% 12%
Common Equity 65% 20%
* The costs of debt and preferred stock are already adjusted for taxes and/or flotation costs. The cost
of equity is unadjusted.
The firm expects to earn $20 million next year, and plans to invest $18 million in new capital
projects. It generally pays dividends equal to 60% of earnings. Flotation costs are 10% for common
and preferred stock.
a. What is Longenes’ initial WACC?
b. Where is the retained earnings breakpoint in the MCC? (Round to the nearest $.1M.)
c. What is the new WACC after the break? (Adjust the entire cost of retained earnings for flotation
d. Longenes can borrow up to $4 million at a net cost of 8% as shown. After that the net cost of debt
rises to 12%. What is the new WACC after the increase in the cost of debt?
e. Where is the second break in the MCC? That is, how much total capital has been raised when the
second increase in WACC occurs?
f. Sketch Longenes’ MCC.

Cost of Capital Comprehensive Problem and IOS: Example 13-10 (page 576) and
Combining the MCC and the IOS (page 575)
25. Taunton Construction Inc.’s capital situation is described as follows:
Debt: The firm issued 10,000 25-year bonds10 years ago at their par value of $1,000. The bonds carry
a coupon rate of 14% and are now selling to yield 10%.
Preferred Stock: 30,000 shares of preferred stock were sold six years ago at a par value of $50. The
shares pay a dividend of $6 per year. Similar preferred issues are now yielding 9%.
Equity: Taunton was initially financed by selling 2 million shares of common stock at $12.
Accumulated retained earnings are now $5 million. The stock is currently selling at $13.25.
Taunton’s Target Capital Structure is as follows:
Debt 30.0%
Preferred Stock 5.0%
Common Equity 65.0%
Other information:
$12.3M $16.0M
Chapter 13
• Taunton’s marginal tax rate (state and federal) is 40%.
• Flotation costs average 12% for common and preferred stock.
• Short-term treasury bills currently yield 7.5%.
• The market is returning 12.5%.
• Taunton’s beta is 1.2.
• The firm is expected to grow at 6% indefinitely.
• The last annual dividend paid was $1.00 per share.
• Taunton expects to earn $5 million next year.
• The firm can borrow an additional $2 million at rates similar to the market return on its old
debt. Beyond that lenders are expected to demand returns in the neighborhood of 14%.
• Taunton has the following capital budgeting projects under consideration in the coming year.
These represent its investment opportunity schedule (IOS).
Capital Cumulative
Project IRR Required Cap. Req.
A 15.0% $3M $3M
B 14.0% $2M $5M
C 13.0% $2M $7M
D 12.0% $2M $9M
E 11.0% $2M $11M
a. Calculate the firm’s capital structure based on book and market values and compare with the target
capital structure. Is the target structure a reasonable approximation of the market value based structure?
Is the book structure very far off?
b. Calculate the cost of debt based on the market return on the company’s existing bonds.
c. Calculate the cost of preferred stock based on the market return on the company’s existing preferred
d. Calculate the cost of retained earnings using three approaches, CAPM, dividend growth, and risk
premium. Reconcile the results into a single estimate.
e. Estimate the cost of equity raised through the sale of new stock using the dividend growth approach.
f. Calculate the WACC using equity from retained earnings based on your component cost estimates
and the target capital structure.
g. Where is the first breakpoint in the MCC (the point where retained earnings runs out)? Calculate to
the nearest $.1M.
h. Calculate the WACC after the first breakpoint.
i. Where is the second breakpoint in the MCC (the point at which the cost of debt increases.) Why does
this second break exist? Calculate to the nearest $.1M.
j. Calculate the WACC after the second break.
k. Plot Taunton’s MCC.
l. Plot Taunton’s IOS on the same axes as the MCC. Which projects should be accepted and which
should be rejected? Do any of those rejected have IRRs above the initial WACC? If so, explain in
words why they’re being rejected.
m. What is the WACC for the planning period?
n. Suppose project E is self-funding in that it comes with a source of its own debt financing. A loan is
offered through an equipment manufacturer at 9%. The cost of the loan is 9% × (1?T) = 5.4%.
Should project E be accepted under such conditions?
The Cost of Capital

$4.2M $6.7M
26. Newrock Manufacturing Inc. has the following target capital structure
Debt 25%,
preferred 20%
equity 55%
Investment bankers have advised the CFO that the company could raise up to $5 million in
new debt financing by issuing bonds at a 6.0% coupon rate, beyond that amount new debt
would require a 7% coupon. Newrock’s 8.5% preferred stock, issued at a par value of $100,
currently sells for $112.50. There are 3,000,000 shares of common stock outstanding on which
the firm paid an annual dividend of $2.00 recently. The stock currently trades at $36 per share.
Next year’s net income is projected at $14,000,000 and management expects 6% growth in the
foreseeable future. Floatation costs are 6% on debt and 11% on common and preferred stock.
The marginal tax rate is 40%.
a. Calculate the WACC using the target capital structure and the cost of retained
earnings for the equity component.
b. Plot Newrock’s MCC identifying the levels of funding at which the first two breaks
occur, and calculate the WACCs after each break.
c. Newrock has identified the following capital projects for next year:
Project Investment IRR
A $ 4.0 million 11.0%
B $ 3.6 million 10.5%
C $ 8.6 million 13.2%
D $ 2.0 million 8.7%
E $ 5.5 million 9.5%
F $ 5.0 million 7.2%
G $ 4.1 million 10.5%
H $ 6.4 million 8.0%
Projects A and B are mutually exclusive, as are Projects C and H. Plot the IOS and the
MCC and determine the ideal size of next year’s capital program.
WACC 9.195% use 9.2%
WACC 9.757% use 9.8%

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