BASIC QUESTIONS (1–25) 1.   Calculating Cost of Equity. Bommer Ltd has just paid a dividend of $2.40 per share on its ordinary shares. The company is expected to maintain a constant 6% growth rate in its dividends indefinitely. If the share price is $48, what is the company's cost of equity? (K)

  (K)
Selected problems are available in McGrawHill Connect Plus. 
2.   Calculating Cost of Equity. Star Jet Ltd's ordinary shares have a beta of 1.3. If the riskfree rate is 5% and the expected return on the market is 13%, what is Star Jet's cost of equity capital? (K)

3.   Calculating Cost of Equity. Shares in Kelpie Industries have a beta of 0.9. The market risk premium is 8%, and shortterm government bonds are currently yielding 4.5%. Kelpie's most recent dividend was $2.60 per share, and dividends are expected to grow at a 5% annual rate indefinitely. If the share price is $48, what is your best estimate of Kelpie's cost of equity? (K)

4.   Estimating the DCF Growth Rate. Suppose Cactus Ltd just paid a dividend of $1.89 per share on its ordinary shares. The company paid dividends of $1.47, $1.62, $1.67 and $1.78 per share in the last four years. If the share price is $65, what is your best estimate of the company's cost of equity capital using arithmetic and geometric growth rates? (K)

5.   Calculating Cost of Preference Shares. Money Penny Bank has an issue of preference shares with a fixed dividend of $6 that just sold for $94. What is the bank's cost of preference shares? (K)

p. 392 6.   Calculating Cost of Debt. ICU Window Ltd is trying to determine its cost of debt. The firm has a debt issue outstanding with seven years to maturity that is quoted at 93% of face value. The issue makes halfyearly payments and has an embedded cost of 5.6% annually. What is ICU's pretax cost of debt? If the tax rate is 30%, what is the aftertax cost of debt? (K)

7.   Calculating Cost of Debt. Jimmy's Cricket Farm issued a thirtyyear, 8% halfyearly bond seven years ago. The bond currently sells for 108% of its face value. The company's tax rate is 30%. a.   What is the pretax cost of debt?  b.   What is the aftertax cost of debt?  c.   Which is more relevant, the pretax or the aftertax cost of debt? Why? (K)


8.   Calculating Cost of Debt. For the firm in Problem 7, suppose the book value of the debt issue is $60 million. In addition, the company has a second debt issue, a zero coupon bond with twenty years left to maturity; the book value of this issue is $70 million, and it sells for 26.5% of par. What is the total book value of debt? The total market value? What is the aftertax cost of debt now? (K)

9.   Calculating WACC. Cobber Farm Ltd has a target capital structure of 70% ordinary shares, 5% preference shares and 25% debt. Its cost of equity is 14%, the cost of preference shares is 6% and the cost of debt is 7.5%. The relevant tax rate is 30%. a.   What is Cobber Farm Ltd's WACC under a classical tax system and an imputation system?  b.   The company CEO has approached you about Cobber Farm's capital structure. He wants to know why the company does not use more preferenceshare financing, since it costs less than debt. 
What would you tell the CEO? (K)

  (K) 
10.   Taxes and WACC. Jorgenson Manufacturing has a target debt–equity ratio of 0.8. Its cost of equity is 14%, and its cost of debt is 8%. If the tax rate is 30%, what is Jorgenson's WACC, given Jorgenson is operating under a classical tax system? What happens to WACC if Jorgenson's was under an imputation system? (K)

11.   Finding the Target Capital Structure. Fama's Llamas has a WACC of 10.5%. The company's cost of equity is 14% and its cost of debt is 8%. The tax rate is 30%. What is Fama's target debt–equity ratio? (Assume a classical tax system.) (K)

12.   Book Value versus Market Value. Fruit Loop Ltd has 10 million ordinary shares outstanding. The current share price is $53, and the book value per share is $1. Fruit Loop also has two bond issues outstanding. The first bond issue has a face value of $75 million, has a 7.5% coupon and sells for 97% of par. The second issue has a face value of $40 million, has a 7% coupon and sells for 96% of par. The first issue matures in twenty years, the second in twelve years.
a.   What are Fruit Loop's capital structure weights on a bookvalue basis?  b.   What are Fruit Loop's capital structure weights on a marketvalue basis?  c.   Which are more relevant, the book or marketvalue weights? Why? (K)


13.   Calculating the WACC. In Problem 12, suppose the most recent dividend is $2.60 and the dividend growth rate is 7%. Assume that the overall cost of debt is the weighted average of that implied by the two outstanding debt issues. Both bonds make halfyearly payments. The tax rate is 30%. What is the company's WACC, assuming a classical tax system? (K)

14.   WACC. Koala Ltd has a target debt–equity ratio of 0.55. Its WACC under a classical tax system is 10.5% and the tax rate is 30%. a.   If Koala's cost of equity is 14%, what is its pretax cost of debt?  b.   If the aftertax cost of debt is 6.5%, what is the cost of equity? (K)


15.   Finding the WACC. Given the following information for Jackaroo Construction Ltd, find the WACC under both a classical and an imputation system. Assume the company's tax rate is 30%. Debt: 6500 bonds, outstanding at 8.5% coupon, $1000 par value, twentyfive years to maturity, selling for 104% of par; the bonds make halfyearly payments.  Ordinary shares: 150 000 shares outstanding, selling for $78 per share; beta is 1.15.  Preference shares: 6.25% preference shares, 10 000 outstanding, currently selling for $80 per share.  Market: 8% market risk premium and 5.25% riskfree rate. (K)


  (K) 
p. 393 16.   Finding the WACC. Gabby Mining Corporation has 9 million ordinary shares outstanding; 500 000 6% preference shares outstanding, and 200 000 9.4% halfyearly bonds outstanding, par value $1000 each. The ordinary shares currently sell for $64 and have a beta of 1.10; the preference shares sell for $83; and the bonds have fifteen years to maturity and sell for 108% of par. The market risk premium is 8%; government bonds are yielding 5.5%; and Gabby Mining's tax rate is 30%. a.   What is the firm's marketvalue capital structure?  b.   If Gabby Mining is evaluating a new investment project that has the same risk as the firm's typical project, what rate should the firm use to discount the project's cash flows under a classical tax system? (K)


  (K) 
17.   SML and WACC. An allequity firm is considering the following projects: The riskfree rate is 5%, and the expected return on the market is 13%. a.   Which projects have a higher expected return than the firm's 13% cost of capital?  b.   Which projects should be accepted?  c.   Which projects would be incorrectly accepted or rejected if the firm's overall cost of capital were used as a hurdle rate? (K)


18.   Calculating the WACC. Calculate the WACC for Widgets Ltd under a classical tax system and imputation system: Debt: 7000 bonds with a 7.5% coupon rate, $1000 face value and a quoted price of $1080. The bonds have twenty years to maturity.  Ordinary shares: 180 000 ordinary shares. The dividends have a growth rate of 6% indefinitely; the current price is $60; and the dividend next year will be $2.80. The beta of the share is 0.9.  Preference share: 8000 5.50% preference shares with a current price of $94.  Market: The corporate tax rate is 30%; the expected return on the market is 12%; and the riskfree rate is 5%. (K)


19.   Calculating the WACC. You are given the following information concerning Cocky Enterprises: Debt: two thousand 7% coupon bonds outstanding, at $1000 face value, with twenty years to maturity and a quoted price of $93. These bonds pay interest halfyearly.  Ordinary shares: 80 000 ordinary shares selling for $45 per share. The share has a beta of 1.2 and will pay a dividend of $3.25 next year. The dividend is expected to grow by 7% per year indefinitely.  Preference shares: seven thousand 6% preference shares selling at $93 per share.  Market: 12% expected return, a 4% riskfree rate and a 30% tax rate. 
Calculate the WACC for Cocky Enterprises under a classical tax system and under an imputation system. (K)

20.   Calculating the WACC. In the previous problem, suppose that Cocky Enterprises thinks that it should have a capital structure of 25% debt, 5% preference shares and 70% equity. Assuming that the cost of each form of financing remains the same, what is Cocky's new cost of capital? (K)

p. 394 21.   Calculating the WACC. Calculate the cost of capital for the following firm under an imputation system: Debt: 8000 9% coupon bonds outstanding, at $1000 face value, twentyfive years to maturity and a quoted price of $104. These bonds pay interest halfyearly.  Ordinary shares: 200 000 ordinary shares selling for $75. The shares have a beta of 1.1 and will pay a dividend of $3.40 next year. The dividend is expected to grow by 7% per year indefinitely.  Market: A 13% expected return, a 6% riskfree rate and 30% tax rate. (K)


22.   Calculating Capital Structure Weights. Kanga Industrial Machines issued 90 000 zero coupon bonds four years ago. The bonds originally had thirty years to maturity with a 8.2% yield to maturity. Interest rates have recently decreased, and the bonds now have a 7.3% yield to maturity. If Kanga has a $40 million market value of equity, what weight should it use for debt when calculating the cost of capital? (K)

23.   Calculating the Cost of Equity. Over the past five years, Alpine Clothing has paid dividends of $1.80, $1.93, $2.02, $2.09 and $2.21. The most recent share price is $51. What is your best estimate of the cost of equity for Alpine Clothing? (K)

24.   Calculating the WACC. Your company has 4 million ordinary shares outstanding with a current market price of $30. The market risk premium is 7.75%, and Treasury bills are yielding 5.5%. There are also sixty thousand $1000 bonds outstanding with a 7.5% halfyearly coupon, eighteen years to maturity and a current price of $960. If the share has a beta of 0.9, what is the WACC for your company under a classical tax system? The tax rate is 30%. (K)

25.   Calculating the WACC. Gnomes ‘R’ Us is considering a new project. The company has a debt–equity ratio of 0.40. The company's cost of equity is 13.5%, and the aftertax cost of debt is 6.25%. The firm believes that the project is riskier than the company as a whole and that it should use an adjustment factor of +3%. What is the WACC it should use for the project under a classical tax system? (K)

INTERMEDIATE QUESTIONS (26–29) 28.   Calculating the Cost of Debt. Ying Import has several bond issues outstanding, each making halfyearly interest payments. The bonds are listed in the table below. If the corporate tax rate is 30%, what is the aftertax cost of Ying's debt? (Assume the bonds' face value is $100.) (K)

p. 395 29.   Calculating the Cost of Equity. Fiji Light Industries shares have a beta of 1.2. The company has just paid a dividend of $0.80, and the dividends are expected to grow at 6%. The expected return of the market is 12.5% and the riskfree rate is 5%. The most recent share price for Fiji Light's ordinary shares is $72. a.   Calculate the cost of equity using the dividend growth model method.  b.   Calculate the cost of equity using the SML method.  c.   Why do you think your estimates in a and b are so different? (K)


CHALLENGE QUESTIONS (30–31) 30.   Flotation Costs and NPV. Photo Corporation (PC) manufactures timeseries photographic equipment. It is currently at its target debt–equity ratio of 0.8. It is considering building a new $80 million manufacturing facility. This new plant is expected to generate aftertax cash flows of $10.9 million in perpetuity. The company raises all equity from outside financing. There are three financing options: a.   A new issue of ordinary shares: The required return on the company's new equity is 17%.  b.   A new issue of twentyyear bonds: If the company issues these new bonds at an annual coupon rate of 9%, they will sell at par.  c.   Increased use of accounts payable financing: Because this financing is part of the company's ongoing daily business, the company assigns it a cost that is the same as the overall firm WACC. Management has a target ratio of accounts payable to longterm debt of 0.20. (Assume there is no difference between the pretax and aftertax accounts payable cost.) 
What is the NPV of the new plant? Assume that the company has a 30% tax rate. (K)

31.   Project Evaluation. This is a comprehensive project evaluation problem, bringing together much of what you have learned in this and previous chapters. Suppose you have been hired as a financial consultant to Defence Electronics Ltd (DEL), a large, publicly traded firm that is the marketshare leader in radar detection systems (RDSs). The company is considering setting up a manufacturing plant overseas to produce a new line of RDSs. This will be a fiveyear project. The company bought some land three years ago for $6 million in anticipation of using it as a toxic dump site for waste chemicals, but it built a piping system to safely discard the chemicals instead. If the land were sold today, the net proceeds would be $6.4 million after taxes. In five years, the land will be worth $7 million after taxes. The company wants to build its new manufacturing plant on this land; the plant will cost $9.8 million to build. The following market data on DEL's securities are current: Debt: twentyfive thousand 6.5% coupon bonds outstanding, twenty years to maturity, selling for 96% of par; the bonds have a $1000 par value each and make halfyearly payments.  Ordinary shares: 400 000 ordinary shares outstanding, selling for $89 per share; the beta is 1.2.  Preference shares: thirtyfive thousand 6.5% preference shares outstanding, selling for $99 per share.  Market: 8% expected market risk premium; 5.2% riskfree rate. 
DEL's tax rate is 30%. The project requires $825 000 in initial net working capital investment to get operational. a.   Calculate the project's Time 0 cash flow, taking into account all side effects.  b.   The new RDS project is somewhat riskier than a typical project for DEL, primarily because the plant is being located overseas. Management has told you to use an adjustment factor of +2% to account for this increased riskiness. Calculate the appropriate discount rate to use under a classical tax system when evaluating DEL's project.  c.   The manufacturing plant has an eightyear tax life, and DEL uses straightline depreciation. At the end of the project (i.e. the end of Year 5), the plant can be scrapped for $1.25 million. What is the aftertax salvage value of this manufacturing plant?  d.   The company will incur $2 100 000 in annual fixed costs. The plan is to manufacture 11 000 RDSs per year and sell them at $10 000 per machine; the variable production costs are $9300 per RDS. What is the annual operating cash flow (OCF) from this project?  e.   Finally, DEL's management wants you to throw all your calculations, all your assumptions and everything else into a report for the chief financial officer: all he wants to know are the RDS project's internal rate of return, IRR and net present value (NPV). What will you report? (K)


