15.1
Calculating the Cost of Equity
Suppose stock in Watta Corporation has a
beta of .80. The market risk premium is 6 percent, and the riskfree rate is 6 per
cent. Watta’s last dividend was $1.20 per share, and the dividend is expected to
grow at 8 percent indefinitely. The stock currently sells for $45 per share. What
is Watta’s cost of equity capital?
15.2
Calculating the WACC
In addition to the information given in the previous
problem, suppose Watta has a target debtequity ratio of 50 percent. Its cost of
debt is 9 percent, before taxes. If the tax rate is 35 percent, what is the WACC?
15.3
Flotation Costs
Suppose in the previous problem Watta is seeking $30 million
for a new project. The necessary funds will have to be raised externally. Watta’s
flotation costs for selling debt and equity are 2 percent and 16 percent, respec
tively. If flotation costs are considered, what is the true cost of the new project?
15.1
We start off with the SML approach. Based on the information given, the ex
pected return on Watta’s common stock is:
R
E
±
R
f
²³
E
´
(
R
M
µ
R
f
)
±
6%
²
.80
´
6%
±
10.80%
We now use the dividend growth model. The projected dividend is
D
0
´
(1
²
g
)
±
$1.20
´
1.08
±
$1.296, so the expected return using this approach is:
R
E
±
D
1
/
P
0
²
g
±
$1.296/45
²
.08
±
10.88%
Because these two estimates, 10.80 percent and 10.88 percent, are fairly close,
we will average them. Watta’s cost of equity is approximately 10.84 percent.
15.2
Because the target debtequity ratio is .50, Watta uses $.50 in debt for every $1
in equity. In other words, Watta’s target capital structure is 1/3 debt and 2/3 eq
uity. The WACC is thus:
WACC
±
(
E
/
V
)
´
R
E
²
(
D
/
V
)
´
(1
µ
T
C
)
±
2/3
´
10.84%
²
1/3
´
9%
´
(1
µ
.35)
±
9.177%%
15.3
Because Watta uses both debt and equity to finance its operations, we first need
the weighted average flotation cost. As in the previous problem, the percentage
of equity financing is 2/3, so the weighted average cost is:
f
A
±
(
E
/
V
)
´
f
E
²
(
D
/
V
)
´
f
D
±
2/3
´
16%
²
1/3
´
2%
±
11.33%
If Watta needs $30 million after flotation costs, then the true cost of the project
is $30 million/(1
µ
f
A
)
±
$30 million/.8867
±
$33.83 million.
Answers to Chapter Review and SelfTest Problems
Chapter Review and SelfTest Problems
CHAPTER 15
Cost of Capital
517
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document1.
WACC
On the most basic level, if a firm’s WACC is 12 percent, what does
this mean?
2.
Book Values versus Market Values
In calculating the WACC, if you had to
use book values for either debt or equity, which would you choose? Why?
3.
Project Risk
If you can borrow all the money you need for a project at 6 per
cent, doesn’t it follow that 6 percent is your cost of capital for the project?
4.
WACC and Taxes
Why do we use an aftertax figure for cost of debt but not
for cost of equity?
5.
This is the end of the preview.
Sign up
to
access the rest of the document.
 Spring '10
 Chadapa
 Weighted average cost of capital

Click to edit the document details