# Cost of Capital End of Book Solutions

Submitted By jberge
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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 tÞ ¼ 10:62985%ð1 À 0:38Þ ¼ 6:5905%
5. C is correct. The bond rating approach depends on knowledge of the company’s rating and can be compared with yields on bonds in the public market.
6. B is correct. The company can issue preferred stock at 6.5%.
Pp ¼ \$1:75=0:065 ¼ \$26:92
7. B is correct. Cost of equity ¼ D1/P0 þ g ¼ \$1.50/\$30 þ 7% ¼ 5% þ 7% ¼ 12%
D=ðD þ EÞ ¼ 0:8033=1:8033 ¼ 0:445
WACC ¼ ½ð0:445Þð0:08Þð1 À 0:4Þ þ ½ð0:555Þð0:12Þ ¼ 8:8%
8. B is correct. The weighted average cost of capital, using weights derived from the current capital structure, is the best estimate of the cost of capital for the average risk project of a company. 9. C is correct. wd ¼ \$63=ð\$220 þ 63Þ ¼ 0:223 we ¼ \$220=ð\$220 þ 63Þ ¼ 0:777

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part-ii-03

13 January 2012; 10:25:56

100

Solutions

10. B is correct. Asset risk does not change with a higher debt-to-equity ratio. Equity risk rises with higher debt.
11. B is correct. The debt-to-equity ratio of the new product should be used when making the adjustment from the asset beta, derived from the comparables, to the equity beta of the new product.
12. B is correct.
Capital…...

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