Principles of Managerial Finance

CHAPTER 11 The Cost of Capital 497

c. Using the constant-growth valuation model, determine the cost of retained

earnings, kr.

d. Using the constant-growth valuation model, determine the cost of new com-

mon stock, kn.

11 – 9 Retained earnings versus new common stock Using the data for each firm

shown in the following table, calculate the cost of retained earnings and

the cost of new common stock using the constant-growth valuation

model.

11 – 10 The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the

effect on its cost of capital of the rate at which the company pays taxes. The firm

wishes to maintain a capital structure of 30% debt, 10% preferred stock, and

60% common stock. The cost of financing with retained earnings is 14%, the

cost of preferred stock financing is 9%, and the before-tax cost of debt financing

is 11%. Calculate the weighted average cost of capital (WACC) given the tax

rate assumptions in parts ato c.

a. Tax rate40%

b. Tax rate35%

c. Tax rate25%

d. Describe the relationship between changes in the rate of taxation and the

weighted average cost of capital.

11 – 11 WACC—Book weights Ridge Tool has on its books the amounts and

specific (after-tax) costs shown in the following table for each source of

capital.

Source of capital Book value Specific cost

Long-term debt $700,000 5.3%

Preferred stock 50,000 12.0

Common stock equity 650,000 16.0

Projected

Current market Dividend dividend per Underpricing Flotation cost

Firm price per share growth rate share next year per share per share

A $50.00 8% $2.25 $2.00 $1.00

B 20.00 4 1.00 0.50 1.50

C 42.50 6 2.00 1.00 2.00

D 19.00 2 2.10 1.30 1.70

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