Problems 253
Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What might be
reasonable costs of capital for average-risk, high-risk, and low-risk projects?
Self-Test Problem (Solution Appears in Appendix A)
Longstreet Communications Inc. (LCI) has the following capital structure, which it considers
to be optimal:debt 25%, preferred stock 15%, and common stock 60%.
LCI’s tax rate is 40 percent and investors expect earnings and dividends to grow at a constant
rate of 9 percent in the future. LCI paid a dividend of $3.60 per share last year (D 0 ), and its
stock currently sells at a price of $60 per share. Treasury bonds yield 11 percent; an average
stock has a 14 percent expected rate of return; and LCI’s beta is 1.51. These terms would apply
to new security offerings:
Preferred:New preferred could be sold to the public at a price of $100 per share, with a divi-
dend of $11. Flotation costs of $5 per share would be incurred.
Debt: Debt could be sold at an interest rate of 12 percent.
a.Find the component costs of debt, preferred stock, and common stock. Assume LCI does
not have to issue any additional shares of common stock.
b.What is the WACC?
Problems
David Ortiz Motors has a target capital structure of 40 percent debt and 60 percent equity. The
yield to maturity on the company’s outstanding bonds is 9 percent, and the company’s tax rate is
40 percent. Ortiz’s CFO has calculated the company’s WACC as 9.96 percent. What is the com-
pany’s cost of equity capital?
Tunney Industries can issue perpetual preferred stock at a price of $50 a share. The issue is ex-
pected to pay a constant annual dividend of $3.80 a share. The flotation cost on the issue is es-
timated to be 5 percent. What is the company’s cost of preferred stock, rps?
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 (D 1 $3.00), and the dividend is expected to
grow at a constant rate of 5 percent a year. What is the cost of common equity?
Calculate the after-tax cost of debt under each of the following conditions:
a.Interest rate, 13 percent; tax rate, 0 percent.
b.Interest rate, 13 percent; tax rate, 20 percent.
c.Interest rate, 13 percent; tax rate, 35 percent.
The Heuser Company’s currently outstanding 10 percent coupon bonds have a yield to matu-
rity of 12 percent. Heuser believes it could issue at par new bonds that would provide a simi-
lar yield to maturity. If its marginal tax rate is 35 percent, what is Heuser’s after-tax cost of
debt?
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, and Trivoli must pay flotation costs of 5 percent of the
market price. What is the cost of the preferred stock for Trivoli?
A company’s 6 percent coupon rate, semiannual payment, $1,000 par value bond which matures
in 30 years sells at a price of $515.16. The company’s federal-plus-state tax rate is 40 percent.
What is the firm’s component cost of debt for purposes of calculating the WACC? (Hint: Base
your answer on the nominalrate.)
6–7
AFTER-TAX COST OF DEBT
6–6
COST OF PREFERRED STOCK
6–5
AFTER-TAX COST OF DEBT
6–4
AFTER-TAX COST OF DEBT
6–3
COST OF EQUITY
6–2
COST OF PREFERRED STOCK
6–1
COST OF EQUITY
ST–1
WACC
6–5
250 The Cost of Capital
