School of Banking and Finance
FINS5514 Capital Budgeting and Financing Decisions
Tutorial Covering Week 5 – Cost of Capital and Raising capital
Multiple Choice Questions
1. Big Bird & Friends is expected to pay their next annual dividend in the amount of
$1.50 a share this week. This dividend is expected to increase by 3 percent annually.
The company’s stock is currently selling for $43.20 per share. What is the cost of
equity?
a. 6.28 percent b. 6.37 percent c. 6.47 percent d. 6.58 percent
Using the dividend growth model, we have:
%47.60647.03
20.43
50.1
0
1
==+=+= g
P
D
RE
Answer: c
2. Ernie and Fred’s has a beta of 1.06. The risk-free rate of return is 3.5 percent and
the market risk premium is 7 percent. What is the cost of equity?
a. 10.10 percent b. 10.92 percent c. 11.13 percent d. 11.26 percent
Using the CAPM, we have:
( ) ( ) %92.101092.007.006.135.0 ==×+=−×+= fMEfE RRRR β
Answer: b
2
3. An increase in interest rates by the Federal Reserve will cause the cost of capital
for a leveraged firm to:
a. remain at its current rate.
b. increase.
c. decrease.
d. change but the direction of that change cannot be predicted.
For a leveraged firm, increases in interest rates will increase the cost of debt. This, in
turn, will increase the WACC overall.
Answer: b
4. Alpha Industries manufactures wood products and has a cost of capital of 12
percent. The Delta Co. is engaged in logging and mining operations and has a 14
percent cost of capital. Both Alpha and Delta are considering purchasing some land
which has just come on the market and contains several thousand log feet of prime
timber. The net present value of this project is $62,500 at a 12 percent discount rate
and a -$14,900 (negative) at a 14 percent discount rate. Which firm or firms, if either,
should purchase this land for its timber?
a. Alpha only
b. Delta only
c. both Alpha and Delta
d. neither Alpha nor Delta
The proposed project is about logging. Therefore, it is Beta’s main line of business but
not Alpha’s. The 12% cost of capital given for Alpha is not suitable for analysing this
project as this is not (presumably) riskier than their usual investments. Considering a
higher discount rate than 12%, the NPV is negative so Alpha should not invest. This is
Beta’s main line of business so using 14% as a discount rate is suitable but the NPV is
negative. Neither firm should invest.
Answer: d
3
Short answer questions
5. The 8.5 percent preferred stock of Flintstone & Daughter is currently selling for
$72 a share. The par value per share is $100. What is the cost of preferred stock for
this firm?

First we need to find the dividend amount which is 8.5% of $100 (the par value). This
is $8.5.
Thus: %81.111181.0
72
5.8
0
====
P
D
RP
6. Your firm has a cost of equity of 11 percent and a pre-tax cost of debt of 9 percent.
You maintain a debt-equity ratio of 0.40 and have a tax rate of 34 percent. What is
your firm’s weighted average cost of capital?
Firstly, find the weights for the debt and equity components of the firm.
A debt-equity ratio of 0.40 means that the total value of the firm is 1.4 of which 0.4 is
debt and 1.0 is equity.
Using the WACC formula without preference shares, we have
This gives
( ) ( ) %55.90955.034.0109.0
4.1
4.0
11.0
4.1
0.1
1 ==





−×




+





=





−×




+





= TR
V
D
R
V
E
WACC DE
4
7. The Brilliant Co. has an overall cost of equity of 10 percent and a beta of 1.20. The
risk-free rate of return is 4 percent. The firm is considering a project with a beta of
0.97 and a four-year life. What is an appropriate cost of equity for this project?
Using the CAPM, we find the market risk premium (MRP) using the information about
the firm: ( ) ( )MRPRRRR fMEfE ×+==−×+= 20.104.010.0β
05.0=MRP
Now looking at the project, we find:
( ) ( ) %85.8085.005.097.004.0 ==×+=−×+= fMEfE RRRR β
8. Targaryen Corporation has a target capital structure of 60% common stock, 5%
preferred stock and 35% debt. Its cost of equity is 12%, the cost of preferred stock
is 5% and pretax cost of debt is 7%. The relevant tax rate is 35%.
a. What is the company's WACC?
b. The company president has approached you about the company's capital
structure. He wants to know why the company doesn't use more preferred stock
financing because it costs less than debt. What would you tell the president?
a. Using the equation for WACC and adjusting for the after-tax cost of debt we have:
( )





−×




+




+





= TR
V
D
R
V
P
R
V
E
WACC DPE 1
( ) ( ) [ ]( ) %04.9904.035.0107.035.005.005.012.06.0 ==−××+×+×=WACC
b. These figures are misleading as they use the pretax cost of debt and it is the after-
tax cost of debt that is important. The after-tax cost is 0.07(1-0.35) = 4.55% which
is cheaper than preferred stock and this is why the firm uses more debt than
preference shares.
5
9. An all-equity firm is considering these projects:
Project Beta IRR
W 0.60 8.8%
X 0.85 9.5
Y 1.15 11.9
Z 1.45 15.0
The t-bill rate is 4%, expected returns on the market is 11%
a. Which projects have a higher expected returns than the firms’ 11% overall cost
of capital?
b. Which projects should be accepted?
c. Which projects would be incorrectly accepted or rejected is the firm’s overall
cost of capital were used as a hurdle rate?
a. Projects Y and Z have IRR’s that exceed the 11% firm cost of capital.
b. Using the CAPM to consider the projects, we can calculate the expected return
of the project given its level of risk. This expected return should then be
compared to the IRR of the project. Recall that the IRR is the discount rate that
gives NPV = 0 so if the expected return on the project is lower than the IRR,
then the project will make money.
( ) ( ) 088.0082.004.011.060.004.0 <=−×+=−×+= fMEfW RRRR β Accept W
( ) ( ) 095.00995.004.011.085.004.0 >=−×+=−×+= fMEfX RRRR β Reject X
( ) ( ) 199.01205.004.011.015.104.0 >=−×+=−×+= fMEfY RRRR β Reject Y
( ) ( ) 150.01415.004.011.045.104.0 <=−×+=−×+= fMEfZ RRRR β Accept Z
c. Using 11% as the hurdle rate we would incorrectly reject project W as its
expected return is only 8.2%. Project Y would be incorrectly accepted.
6
10. A firm needs to raise $55 million for a new project and raises the money by selling
bonds. Target capital structure is 70% common stock, 5% preferred stock and 25%
debt. Flotation costs for new common stock are 9%, for new preferred stock are 6%
and for new debt 3%. What is the true initial cost figure that the company should
use when evaluating the project?
The total flotation cost is the weighted average of the individual flotation costs:
=(/)+(/)+(/)=(0.07×0.09)+(0.05×0.06)+(0.025×0.03)=0.0735
=7.35%
Therefore, the total cost of the equipment including flotation costs is:
× (1−0.0735)=$55,000,000
= 55,000,000(1−0.0735)=$59,363,195
11. A firm is considering a project which will result in initial after-tax savings of $1.8
million at the end of the first year and these savings will grow at a rate of 2% per
year indefinitely. The firm has a target debt-equity ratio of 0.80, a cost of equity of
12% and an after-tax cost of debt of 4.8%. The cost-saving proposal is somewhat
riskier than the usual firm investment; the management employs a subjective
approach and applies an adjustment of factor of +2% to the cost of capital for such
projects. Should the firm take the project?
Start by calculating the firm WACC
=(/)+[(/)×(1−)]=(1.0/1.8)0.12+[(0.8/1.8)(0.048)]=0.0880=8.80%
Since the project is riskier than the company, we need to adjust the project discount
rate for the additional risk. Using the subjective risk factor given, we find:
= 8.80% + 2.00% = 10.80%
7
The NPV is the PV of the cash outflows plus the PV of the cash inflows. In this case, the
cash inflows are a growing perpetuity. The equation for the PV of a growing perpetuity
is:
=/(−) = 1,800,000/(0.1080−0.02)=$20,454,545
The project should only be undertaken if its cost is less than $20,454,545 since costs
less than this amount will result in a positive NPV.