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Cost of Debt

Micro Spinoffs, Inc., issued 20-year debt a year ago at par value with a coupon rate of 9 percent, paid annually. Today, the debt is selling at $1,050. If the firm`s tax bracket is 35 percent, what is its after-tax cost of debt?

2. Cost of Preferred Stock. Micro Spinoffs also has preferred stock outstanding. The stock pays a dividend of $4 per share, and the stock sells for $40. What is the cost of preferred stock?

3. Calculating WACC. Suppose Micro Spinoffs`s cost of equity is 12.5 percent. What is its WACC if equity is 50 percent, preferred stock is 20 percent, and debt is 30 percent of total capital?

4. Cost of Equity. Reliable Electric is a regulated public utility, and it is expected to provide steady growth of dividends of 5 percent per year for the indefinite future. Its last dividend was $5 per share; the stock sold for $60 per share just after the dividend was paid. What is the company`s cost of equity?

5. Calculating WACC. Reactive Industries has the following capital structure. Its corporate tax rate is 35 percent. What is its WACC?

6. Company versus Project Discount Rates. Geothermal`s WACC is 11.4 percent. Executive Fruit`s WACC is 12.3 percent. Now Executive Fruit is considering an investment in geothermal power production. Should it discount project cash flows at 12.3 percent? Why or why not?

7. Flotation Costs. A project costs $10 million and has NPV of $+2.5 million. The NPV is computed by discounting at a WACC of 15 percent. Unfortunately, the $10 million investment will have to be raised by a stock issue. The issue would incur flotation costs of $1.2 million. Should the project be undertaken?

8. WACC. The common stock of Buildwell Conservation & Construction, Inc., has a beta of .80. The Treasury bill rate is 4 percent and the market risk premium is estimated at 8 percent. BCCI`s capital structure is 30 percent debt paying a 5 percent interest rate, and 70 percent

equity. What is BCCI`s cost of equity capital? Its WACC? Buildwell pays no taxes.

9. WACC and NPV. BCCI (see the previous problem) is evaluating a project with an internal rate of return of 12 percent. Should it accept the project? If the project will generate a cash flow of $100,000 a year for 7 years, what is the most BCCI should be willing to pay to initiate the project?

10. Calculating WACC. Find the WACC of William Tell Computers. The total book value of the firm`s equity is $10 million; book value per share is $20. The stock sells for a price of $30 per share, and the cost of equity is 15 percent. The firm`s bonds have a par value of $5 million and sell at a price of 110 percent of par. The yield to maturity on the bonds is 9 percent, and the firm`s tax rate is 40 percent.

11. WACC. Nodebt, Inc., is a firm with all-equity financing. Its equity beta is .80. The Treasury bill rate is 5 percent and the market risk premium is expected to be 10 percent. What is Nodebt`s asset beta? What is Nodebt`s weighted-average cost of capital? The firm is exempt

from paying taxes.

12. Cost of Capital. A financial analyst at Dawn Chemical notes that the firm`s total interest payments this year were $10 million while total debt outstanding was $80 million, and he concludes that the cost of debt was 12.5 percent. What is wrong with this conclusion?

13. Cost of Equity. Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 30 percent, and the current dividend yield is 2 percent. Its beta is 1.2, the market risk premium is 8 percent, and the risk-free rate is 4 percent.

a. Calculate two estimates of the firm`s cost of equity.

b. Which estimate seems more reasonable to you? Why?

14. Cost of Debt. Olympic Sports has two issues of debt outstanding. One is a 9 percent coupon bond with a face value of $20 million, a maturity of 10 years, and a yield to maturity of 10 percent. The coupons are paid annually. The other bond issue has a maturity of 15 years, with

coupons also paid annually, and a coupon rate of 10 percent. The face value of the issue is $25 million, and the issue sells for 92.8 percent of par value. The firm`s tax rate is 35 percent.

a. What is the before-tax cost of debt for Olympic?

b. What is Olympic`s after-tax cost of debt?

15. Capital Structure. Examine the following book-value balance sheet for University Products, Inc. What is the capital structure of the firm based on market values? The preferred stock currently sells for $15 per share and the common stock for $20 per share. There are one million common shares outstanding.

16. Calculating WACC. Turn back to University Products`s balance sheet from the previous problem. If the preferred stock pays a dividend of $2 per share, the beta of the stock is .8, the market risk premium is 10 percent, the risk-free rate is 6 percent, and the firm`s tax rate is 40 percent, what is University`s weighted-average cost of capital?

17. Project Discount Rate. University Products is evaluating a new venture into home computer systems (see problems 15 and 16). The internal rate of return on the new venture is estimated at 13.4 percent. WACCs of firms in the personal computer industry tend to average around 14 percent. Should the new project be pursued? Will University Products make the correct decision if it discounts cash flows on the proposed venture at the firm`s WACC?

18. Cost of Capital. The total market value of Okefenokee Real Estate Company is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock currently is 1.5 and that the expected risk premium on the market is 10 percent. The Treasury

bill rate is 4 percent.

a. What is the required rate of return on Okefenokee stock?

b. What is the beta of the company`s existing portfolio of assets? The debt is perceived to be virtually risk-free.

c. Estimate the weighted-average cost of capital assuming a tax rate of 40 percent.

d. Estimate the discount rate for an expansion of the company`s present business.

e. Suppose the company wants to diversify into the manufacture of rose-colored glasses. The beta of optical manufacturers with no debt outstanding is 1.2. What is the required rate of return on Okefenokee`s new venture?