328 Part 4 Investing in Long-Term Assets: Capital Budgeting
EFFECT ON
rd(1 # T) rs WACCa. The corporate tax rate is lowered.
b. The Federal Reserve tightens credit.
c. The firm uses more debt; that is, it
increases its debt/assets ratio.
d. The dividend payout ratio is increased.
e. The firm doubles the amount of capital
it raises during the year.
f. The firm expands into a risky new area.
g. The firm merges with another firm
whose earnings are countercyclical
both to those of the first firm and to the
stock market.
h. The stock market falls drastically, and
the firm’s stock price falls along with
the rest of the stocks.
i. Investors become more risk-averse.
j. The firm is an electric utility with a large
investment in nuclear plants. Several
states are considering a ban on nuclear
power generation.Assume that the risk-free rate increases. What impact would this have on the cost of debt?
What impact would it have on the cost of equity?
How should the capital structure weights used to calculate the WACC be determined?
Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all
of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs
of capital for average-, high-, and low-risk projects?
The WACC is a weighted average of the costs of debt, preferred stock, and common
equity. Would the WACC be different if the equity for the coming year came solely in the
form of retained earnings versus some equity from the sale of new common stock? Would
the calculated WACC depend in any way on the size of the capital budget? How might
dividend policy affect the WACC?AFTER!TAX COST OF DEBT The Heuser Company’s currently outstanding bonds have a
10% coupon and a 12% yield to maturity. Heuser believes it could issue new bonds at par
that would provide a similar yield to maturity. If its marginal tax rate is 35%, what is
Heuser’s after-tax cost of debt?
COST OF PREFERRED STOCK Tunney Industries can issue perpetual preferred stock at a
price of $47.50 a share. The stock would pay a constant annual dividend of $3.80 a share.
What is the company’s cost of preferred stock, rp?
COST OF COMMON EQUITY Percy Motors has a target capital structure of 40% debt and
60% common equity, with no preferred stock. The yield to maturity on the company’s
outstanding bonds is 9%, and its tax rate is 40%. Percy’s CFO estimates that the company’s
WACC is 9.96%. What is Percy’s cost of common equity?10-210-2
10-310-3
10-410-4
10-510-5
PROBLEMPROBLEMSS
Easy 10-110-1
Problems 1–5Easy
Problems 1–5