Graded Homework

Problem Set on the Cost of Capital, Part
I

1. Thatcher Corporation’s bonds will mature in 10
years. The bonds have a face value of $1,000 and an 8 percent coupon rate, paid
semiannually. The price of the bond is $1,100. What is the firm’s cost
(percentage rate) of borrowing money under these market conditions?

2. Bruner
Aeronautics has preferred stock outstanding with a par value of $100. The stock
pays a quarterly dividend of $2 and has a current price of $80. What will be
Bruner’s cost of funds if the company decided to issue new preferred stocks?

3. Javits
& Sons’ common stock is currently trading at $30 a share. The stock is
expected to pay a dividend of $3.00 a share at the end of the year (D₁=$3.00),
and the dividend is expected to grow at a constant rate of 5 percent a year. If
the company were to issue external equity, it would incur a 10 percent
flotation cost. What are the costs of internal and external equity?

4. The
Heuser Company’s currently outstanding 10 percent coupon bonds have a yield to
maturity of 12 percent. Heuser believes it could issue at par new bonds that
would provide a similar yield to maturity. If its marginal tax rate is 35
percent, what is Heuser’s after-tax cost of debt?

5. Trivoli
Industries plans to issue some $100 par preferred stock with an 11 percent
dividend. The stock is selling on the market for $97.00, but Trivoli must pay
flotation costs of 5 percent of the market price, so the net price the firm
will receive is $92.15 per share. What is Trivoli’s cost of preferred stock
with flotation considered?

6. The earnings, dividends, and
stock price of Carpetto Technologies Inc. are expected to grow at 7 percent per
year in the future. Carpetto’s common stock sells for $23 per share, its last
dividend was $2.00, and the company will pay a dividend of $2.14 at the end of
the current year.

a. Using the discounted cash
flow approach, what is its cost of common equity?

D1 / P0 + g = $2.14 / $23 + 7% = 9.3% + 7% =
16.3%.

b. If the firm’s beta is 1.6,
the risk-free rate is 9 percent, and the average return on the market is 13
percent, what will be the firm’s cost of common equity using the CAPM approach?

	:	15.4%
		rs = rRF + (rM – rRF)b rs= 9% + (13% – 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.

c. If the firm’s bonds earn a
return of 12 percent, what will be the firm’s cost of common equity using the own-bond-yield-plus-risk-premium?
(Use a risk premium of 4%.)

Bond rate + Risk premium = 12% + 4% = 16%.

d. On the basis of the results
obtained in parts a through c, what would you
estimate Carpetto’s cost of common equity to be?