Applied Software has $1,000 par value bonds outstanding at 16 percent interest. The bonds will mature in 20 years. Use Appendix B and Appendix D.

Compute the current price of the bonds if the present yield to maturity is (Round “PV Factor” to 3 decimal places, intermediate and final answers to 2 decimal places. Omit the “$” sign in your response):

Price of the
bond

  (a) 8 percent

$  on investment

(2)

  K_e increases

(3)

  g increases

Speedy Delivery Systems can buy a piece of equipment that should provide an 8 percent return and can be financed at 5 percent with debt. The CEO likes earning more than the cost of debt, and he thinks this would be a good deal. The firm can also buy a machine that would yield a 16 percent return but would cost 18 percent to finance through common equity. Earning less than the cost of equity sounds bad to the CEO. Assume debt and common equity each represent 50 percent of the firm’s capital structure.

(a)

Compute the weighted average cost of capital. (Round your intermediate and final answers to 1 decimal place. Omit the “%” sign in your response.)

  Weighted average cost of capital

[removed] %  

(b)

Which project(s) should be accepted?

A brilliant young scientist is killed in a plane crash. It was anticipated that he could have earned $210,000 a year for the next 20 years. The attorney for the plaintiff’s estate argues that the lost income should be discounted back to the present at 4 percent. The lawyer for the defendant’s insurance company argues for a discount rate of 15 percent.

What is the difference between the present value of the settlement at 4 percent and 15 percent? Compute each one separately. Use Appendix D. (Round “PV Factor” to 3 decimal places. Round your answers to the nearest dollar amount. Omit the “$” sign in your response)

Present value

  PV at 4% rate

$

[removed]  

  PV at 15% rate

[removed]  

  Difference

$

[removed]  

Calculate the aftertax cost of debt under each of the following conditions. (Round your answers to 2 decimal places. Omit the “%” sign in your response.)

Yield

Corporate
tax rate

Cost of debt

 a.

7.0

 %

31

 %

[removed] %

 b.

14.0

25

[removed]    

 c.

15.5

25

[removed]    

The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 9 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 25 percent higher; that is, firms that paid 11 percent for debt last year will be paying 13.75 percent this year.

(a)

If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on its cost last year and the 25 percent increase? (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of debt

[removed] %  

(b)

If the receipts of the foundation were found to be taxable by the IRS (at a rate of 35 percent because of involvement in political activities), what would the aftertax cost of the debt be? (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

Airbone Airlines, Inc., has a $1,000 par value bond outstanding with 30 years to maturity. The bond carries an annual interest payment of $100 and is currently selling for $880. Airbone is in the 25 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

(a)

Compute the approximate yield to maturity on the old issue and use this as the yield for the new issue.(Do not round intermediate calculations. Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Yield on new issue

[removed] %  

(b)

Make the appropriate tax adjustment to determine the aftertax cost of debt. (Do not round intermediate calculations. Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of debt

[removed] %  

Russell Container Corporation has a $1,800 par value bond outstanding with 20 years to maturity. The bond carries an annual interest payment of $111 and is currently selling for $1,200 per bond. Russell Corp. is in a 20 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

Assume that the yield on the bonds goes up by 1 percentage point and that the tax rate is now 39 percent.

(a)

What is the new after-tax cost of debt? (Hint: Use the approximate yield to maturity to compute after-tax cost of debt) (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of debt

[removed] %  

(b)

Has the aftertax cost of debt gone up or down?

KFW is planning to issue debt that will mature in the year 2012. In many respects the issue is similar to currently outstanding debt of the corporation. Using Table 11-2, identify:

(a)

The yield to maturity on similarly outstanding debt for the firm, in terms of maturity. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

(b)

Calculate yield to maturity with an increase of 0.25 percent than the value determined in part a. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

(c)

If the firm is in a 40 percent tax bracket, what is the aftertax cost of debt for yield determined in part b?(Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of debt

[removed] %  

The Meredith Corporation issued $100 par value preferred stock 10 years ago. The stock provided an 10 percent yield at the time of issue. The preferred stock is now selling for $70. (Disregard flotation costs.)

What is the current yield or cost of preferred stock? (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 1 percent less than that for preferred stock.

     Debt can be issued at a yield of 8.6 percent, and the corporate tax rate is 30 percent. Preferred stock will be priced at $54 and pay a dividend of $3.80. The flotation cost on the preferred stock is $2.

(a)

Compute the aftertax cost of debt. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Aftertax cost of debt

[removed] %  

(b)

Compute the aftertax cost of preferred stock. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Aftertax cost of preferred stock

[removed] %  

(c)

Based on the facts given above, is the treasurer correct?

Compute K_e and K_n under the following circumstances:

(a)

D₁ = $8.00, P₀ = $82, g = 7%, F = $6.00. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

  K_e

[removed] %  

  K_n

[removed] %  

(b)

D₁ = $0.50, P₀ = $46, g = 3%, F = $4.50. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

  K_e

[removed] %  

  K_n

[removed] %  

(c)

E₁ (earnings at the end of period one) = $13, payout ratio equals 40 percent, P₀ = $46, g = 3.5%, F = $2.10. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

  K_e

[removed] %  

  K_n

[removed] %  

(d)

D₀ (dividend at the beginning of the first period) = $6, growth rate for dividends and earnings (g) = 4%, P₀= $72, F = $3. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

  K_e

[removed] %  

  K_n

[removed] %  

United Business Forms’ capital structure is as follows:

  Debt

40

%

  Preferred stock

15

  Common equity

45

The aftertax cost of debt is 11 percent, the cost of preferred stock is 14 percent, and the cost of common equity (in the form of retained earnings) is 17 percent.

Calculate United Business Forms’ weighted cost of each source of capital and the weighted average cost of capital. (Round your answers to 2 decimal places. Omit the “%” sign in your response.)

Weighted cost

  Debt (K_d)

[removed]

%  

  Preferred stock (K_p)

[removed]

  Common equity (K_e)

[removed]

  Weighted average cost of capital (K_a)

[removed]

%  

Sauer Milk, Inc., wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:

Cost
(aftertax)

Weights

  Plan A

  Debt

5.0

%

20

%

  Preferred stock

10.0

10

  Common equity

14.0

70

  Plan B

  Debt

5.2

%

30

%

  Preferred stock

10.2

10

  Common equity

15.0

60

  Plan C

  Debt

6.0

%

40

%

  Preferred stock

15.7

10

  Common equity

11.6

50

  Plan D

  Debt

12.0

%

50

%

  Preferred stock

16.6

10

  Common equity

13.6

40

(a-1)

Compute the weighted average cost for four plans. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

Weighted cost

  Plan A

[removed] %  

  Plan B

[removed]      

  Plan C

[removed]      

  Plan D

[removed]      

(a-2)

Which of the four plans has the lowest weighted average cost of capital?

(b)

Among Plan C and Plan D, which has higher weighted average cost of capital.

A-Rod Manufacturing Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr. Jeter, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

     The company currently has outstanding a bond with a 9.6 percent coupon rate and another bond with an 7.2 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 10.5 percent. The common stock has a price of $50 and an expected dividend (D₁) of $1.70 per share. The historical growth pattern (g) for dividends is as follows:

$1.25

1.39

1.54

1.70

     The preferred stock is selling at $70 per share and pays a dividend of $6.60 per share. The corporate tax rate is 30 percent. The flotation cost is 2.0 percent of the selling price for preferred stock. The optimum capital structure for the firm is 25 percent debt, 10 percent preferred stock, and 65 percent common equity in the form of retained earnings.

(a)

Compute the historical growth rate. (Round your intermediate calculations and your final answer to 2 decimal Places. Omit the “%” sign in your response.)

  Growth rate

[removed] %  

(b)

Compute the cost of capital for the individual components in the capital structure. (Round growth rate to nearest whole percent. Round your answers to 2 decimal places. Omit the “%” sign in your response.)

Cost of capital

  Debt (K_d)

[removed] %  

  Preferred stock (K_p)

[removed]      

  Common equity (K_e)

[removed]      

(c)

Calculate the weighted cost of each source of capital and the weighted average cost of capital. (Round your intermediate calculations and  final answers to 2 decimal places. Omit the “%” sign in your response.)

Weighted cost

  Debt (K_d)

[removed] %  

  Preferred stock (K_p)

[removed]      

  Common equity (K_e)

[removed]      

  Weighted average cost of capital (K_a)

[removed] %  

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 35 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

     Historically, the corporation’s earnings and dividends per share have increased about 4.6 percent annually and this should continue in the future. Northwest’s common stock is selling at $69 per share, and the company will pay a $6.20 per share dividend (D₁).

     The company’s $106 preferred stock has been yielding 6 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $4.00 for preferred stock.

     The company’s optimum capital structure is 35 percent debt, 10 percent preferred stock, and 55 percent common equity in the form of retained earnings. Refer to the table below on bond issues for comparative yields on bonds of equal risk to Northwest.

Data on Bond Issues

  Issue

Moody’s
rating

Price

Yield to maturity

  Utilities:

     Southwest electric power––7¹/₄ 2023

Aa2

$

920.18

8.66

%

     Pacific bell––7³/₈ 2025

Aa3

896.25

8.44

     Pennsylvania power & light––8¹/₂ 2022

A2

995.66

8.45

  Industrials:

     Johnson & Johnson––6³/₄ 2023

Aaa

850.24

8.35

%

     Dillard’s Department Stores––7¹/₈ 2023

A2

910.92

8.88

     Marriott Corp.––10 2015

B2

1,060.10

9.55

(a)

Compute the cost of debt, K_d (use the accompanying table—relate to the utility bond credit rating for yield.) (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of debt

[removed] %  

(b)

Compute the cost of preferred stock, K_p. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of preferred stock

[removed] %  

(c)

Compute the cost of common equity in the form of retained earnings, K_e. (Round your answer to 2 decimal places. Omit the “%” sign in your response.)

  Cost of common equity

[removed] %  

(d)

Compute the weighted average cost of capital. (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)

Weighted cost

  Debt (K_d)

[removed] %  

  Preferred stock (K_p)

[removed]     

  Common equity (K_e)

[removed]      

  Weighted average cost of capital (K_a)

[removed] %  

Delta Corporation has the following capital structure:

Cost
(aftertax)

Weights

Weighted
cost

  Debt (K_d)

6.6

%

20

%

1.32

%

  Preferred stock (K_p)

11.2

10

1.12

  Common equity (K_e) (retained earnings)

11.2

70

7.84

  Weighted average cost of capital (K_a)

10.28

%

(a)

If the firm has $49 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions. Omit the “$” sign in your response.)

  Capital structure size (X)

$ [removed] million  

(b)

The 6.6 percent cost of debt referred to above applies only to the first $23 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? (Enter your answer in millions. Omit the “$” sign in your response.)

  Capital structure size (Z)

$ [removed] million  

The Nolan Corporation finds that it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 45 percent debt, 15 percent preferred stock, and 40 percent common equity. Initially common equity will be in the form of retained earnings (K_e) and then new common stock (K_n). The costs of the various sources of financing are as follows: debt, 4.2 percent; preferred stock, 6 percent; retained earning, 14 percent; and new common stock, 15.2 percent.

(a)

What is the initial weighted average cost of capital? (Round your intermediate calculations and final answer to 2 decimal places. Omit the “%” sign in your response.)

  Weighted average cost of capital

[removed] %  

(b)

If the firm has $26 million in retained earnings, at what size capital structure will the firm run out of retained earnings? (Enter your answer in millions. Omit the “$” sign in your response.)

  Capital structure size (X)

$ [removed] million  

(c)

What will the marginal cost of capital be immediately after that point? (Equity will remain at 40 percent of the capital structure, but will all be in the form of new common stock, K_n.)(Round your intermediate calculations and final answer to 2 decimal places. Omit the “%” sign in your response.)

  Marginal cost of capital

[removed] %  

(d)

The 4.2 percent cost of debt referred to above applies only to the first $45 million of debt. After that the cost of debt will be 6.5 percent. At what size capital structure will there be a change in the cost of debt?(Enter your answer in millions. Omit the “$” sign in your response.)

  Capital structure size (Z)

$ [removed] million  

(e)

What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts cand d.) (Round your intermediate calculations and final answer to 2 decimal places. Omit the “%” sign in your response.)

  Marginal cost of capital

[removed] %  

Eaton Electronic Company’s treasurer uses  both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume:

R_f

=

5

%

K_m

=

11

%

β

=

1.3

D₁

=

$

.75

P₀

=

$

15

g

=

9

%

(a)

Compute K_i (required rate of return on common equity based on the capital asset pricing model).(Round your final answers to 2 decimal places. Omit the “%” sign in your response.)

(b)

Compute K_e (required rate of return on common equity based on the dividend valuation model). (Round your intermediate and final answers to 2 decimal places. Omit the “%” sign in your response.)