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Directions: You MUST show ALL of your work to receive credit on the problems. There will be significant point reductions if you do not show your work. All calculations should be completed to at least 2 decimal places.

1) What is a firm's weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket.

2) Compute the weighted-average cost of capital for a firm with the following sources of funds and corresponding required rates of return: $5 million common stock at 16%, $500,000 preferred stock at 10%, and $3 million debt at 9%. All amounts are listed at market values and the firm's tax rate is 35%.

3) Calculate a firm's required rates of return for both of its equity components: Its common stock sells for $50 per share and will pay a $6 dividend next year which is expected to grow at a constant 5% rate. Its preferred stock sells for $22.50 per share and pays $1.80 in dividends. What accounts for the difference in returns, given that these are both forms of equity?

4) Why can faulty decisions be made when all capital budgeting proposals are evaluated at the firm's current weighted average cost of capital?

5)

Here is some information about Stokenchurch Inc.:

Beta of common stock = 1.2

Treasury bill rate = 4%

Market risk premium = 7.5%

Yield to maturity on long- term debt = 6%

Book value of equity = $ 440 million

Market value of equity = $ 880 million

Long- term debt outstanding = $ 880 million

Corporate tax rate = 35%

What is the company’s WACC?

Explanation / Answer

1. Weight of debt = Wd = 0.3

Weight of equity = We = 0.6

Cost of equity = Re = Rf + beta*(Rm- Rf) = 5 + 1.45*(14-5) = 18.05%

After tax cost of debt = Rd = Pretax cost*(1-tax rate ) = 9*(1-0.35) = 5.85%

Hence WACC = Re*We + Rd* Wd = 18.05*0.6 + 5.85*0.3 = 12.585% = 12.59%

2. Total Capital = 5,000,000 + 500,000 + 3,000,000 = 8.500,000

Weight of equity = We = 5/8.5 = 0.5882

Weight of preferreed Stock = Wpf = 0.5/8.5 = 0.0588

Weight of debt = 1-0.0588 -0.5882 = 0.3530

Cost of Equity = Re = 16%

Cost of preferred stock = Rpf = 10%

After tax cost of debt = Rd = 9*(1-0.35) = 5.85%

WACC = 0.5882*16 + 0.0588*10 + 0.3530*5.85 = 12.06%

3. Required rate for Common equity = D1/P0 + g = 6/50 + 0.05 = 0.17 = 17%

Required rate for preferred stock = Dividend/ Price = 1.80/22.50 = 0.08 = 8%

The difference is becuase the dividends in preferred stock are fixed whereas the ones in common equity are growing at a rate of 5%

4.

Yes, there could be possibility of faulty decisions when all proposals are evaluated using the current weighted average cost of capital.

There can be certain projects with a higher or lower risk than the weighted average cost of capital (WACC) of the firm. Hence using the WACC always may not be correct

If a particular project is having a higher risk, than the discount rate used should be higher than the WACC. Alternatively, if a particular project is having a lower risk, than the discount rate used should be lower than the WACC.

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