Cost of Capital End of Book Solutions

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CHAPTER 3 COST OF CAPITAL SOLUTIONS 1. B is correct. The cost of equity is defined as the rate of return required by stockholders. 2. B is correct. Debt is generally less costly than preferred or common stock. The cost of debt is further reduced if interest expense is tax deductible. 3. C is correct. First calculate the growth rate using the sustainable growth calculation, and then calculate the cost of equity using the rearranged dividend discount model: g ¼ ð1 À Dividend payout ratioÞðReturn on equityÞ ¼ ð1 À 0:30Þð15%Þ ¼ 10:5% re ¼ ðD1 =P0 Þ þ g ¼ ð$2:30=$45Þ þ 10:50% ¼ 15:61% 4. C is correct. FV ¼ $1,000; PMT ¼ $40; N ¼ 10; PV ¼ $900 Solve for i. The six-month yield, i, is 5.3149%. YTM ¼ 5:3149% 3 2 ¼ 10:62985% rd ð1 À…show more content…
B is correct. Asset betas: βequity/[1 þ (1 À t)(D/E)] Relevant ¼ 1:702=½1 þ ð0:77Þð0ފ ¼ 1:702 ABJ ¼ 2:8=½1 þ ð0:77Þð0:003ފ ¼ 2:7918 Opus ¼ 3:4=1 þ ½ð0:77Þð0:013ފ ¼ 3:3663 20. C is correct. Weights are determined based on relative market values: Pure-Play Market Value of Equity in Billions Proportion of Total Relevant $3.800 0.5490 ABJ 2.150 0.3106 Opus 0.972 0.1404 Total $6.922 1.0000 Weighted average beta ¼ ð0:5490Þð1:702Þ þ ð0:3106Þð2:7918Þ þ ð0:1404Þð3:3572Þ ¼ 2:27 21. B is correct. Asset beta ¼ 2:27 Levered beta ¼ 2:27f1 þ ½ð1 À 0:23Þð0:01ފg ¼ 2:2875 Cost of equity capital ¼ 0:0525 þ ð2:2875Þð0:07Þ ¼ 0:2126 or 21:26% 22. C is correct. For debt: FV ¼ 2,400,000; PV ¼ 2,156,000; n ¼ 10; PMT ¼ 150,000 Solve for i. i ¼ 0.07748. YTM ¼ 15.5% Before-tax cost of debt ¼ 15.5% Market value of equity ¼ 1 million shares outstanding plus 1 million newly issued shares ¼ 2 million shares at $8 ¼ $16 million part-ii-03 13 January 2012; 10:25:56 102 Solutions Total market capitalization ¼ $2.156 million þ $16 million ¼ $18.156 million Levered beta ¼ 2.27{1 þ [(1 À 0.23)(2.156/16)]} ¼ 2.27 (1.1038) ¼ 2.5055 Cost of equity ¼ 0.0525 þ 2.5055(0.07) ¼ 0.2279 or 22.79% Debt weight ¼ $2.156/$18.156 ¼ 0.1187 Equity weight ¼ $16/$18.156 ¼ 0.8813 TagOn’s MCC ¼ ½ð0:1187Þð0:155Þð1 À 0:23ފ þ ½ð0:8813Þð0:2279ފ ¼ 0:01417 þ 0:20083 ¼ 0:2150 or 21:50% 23. A is correct. The

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