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08%20cost%20of%20capital%20test%20bank%20problems%20solutions

# 08%20cost%20of%20capital%20test%20bank%20problems%20solutions

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FNAN 301 Solutions to test bank problems – cost of capital Some answers may be slightly different than provided solutions due to rounding 1. Last Stand Corp. has 700,000 shares of common equity outstanding that have an expected return of 16% and a current price of \$40 each. The expected return on the market is 13% and the risk-free rate is 3%. Last Stand has issued 50,000 bonds with a face value of \$1,000 and a market value of \$920 each. The yield to maturity on these bonds is 8% and the annual coupon rate is 6%. If the corporate tax rate is 30%, what is the weighted-average cost of capital for Last Stand Corp? (Fall 2009, final, question 19) (Spring 2010, final, question 19) WACC = [(E/V) × R E ] + [(D/V) × R D × (1 – Tc)] V = E + D Expected returns R E = .160 = 16.0% R D = YTM = .080 = 8.0% = pre-tax cost of debt Values E = number of shares × market price (value) per share = 700,000 × \$40 = \$28,000,000 D = number of bonds × market price (value) per bond = 50,000 × \$920 = \$46,000,000 V = E + D = \$28,000,000 + \$46,000,000 = \$74,000,000 Taxes Tc = 0.30 WACC WACC = [(E/V) × R E ] + [(D/V) × R D × (1 – Tc)] = [(28m/74m) × .160] + [(46m/74m) × .080 × (1 – .30)] = .0605 + .0348 = .0953 = 9.53% Answers may differ slightly due to rounding 1

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FNAN 301 Solutions to test bank problems – cost of capital 2. The Green Forest Company has 1,000,000 shares of preferred equity outstanding that have an expected return of 12% and a current price of \$17 each. Green Forest has 2,000,000 shares of common equity outstanding that have an expected return of 18% and a current price of \$38 each. The expected return on the market is 10% and the risk-free rate is 3%. Green Forest has issued 50,000 bonds with a face value of \$1,000 and a market value of \$940 each. The annual coupon rate on these bonds is 7% and their yield-to-maturity is 9%. If the corporate tax rate is 40%, what is the weighted- average cost of capital for Green Forest? (Summer C 2010, final, question 24) WACC = [(E/V) × R E ] + [(P/V) × R P ] + [(D/V) × R D × (1 – Tc)] V = E + P + D Expected returns R E = .180 = 18.0% R P = .120 = 12.0% R D = YTM = 9.0% = pre-tax cost of debt Values E = number of common shares × market price (value) per share = 2,000,000000 × \$38 = \$76,000,000 P = number of preferred shares × market price (value) per share = 1,000,000 × \$17 = \$17,000,000 D = number of bonds × market price (value) per bond = 50,000 × \$940 = \$47,000,000 V = E + P + D = \$17,000,000 + \$76,000,000 + \$47,000,000 = \$140,000,000 Taxes Tc = 0.40 WACC WACC = [(E/V) × R E ] + [(P/V) × R P ] + [(D/V) × R D × (1 – Tc)] = [(76m/140m) × .18] + [(17m/140m) × .12] + [(47m/140m) × .09 × (1 – .40)] .0977 + .0146 + .0181 = .1304 = 13.04% Answers may differ slightly due to rounding 2
FNAN 301 Solutions to test bank problems – cost of capital 3. The weighted-average cost of capital for Castle Hotel Company is 9.0 percent. The firm has equity valued at \$100 million and debt valued at \$200 million. The firm’s debt has an expected return of 9.0 percent and the corporate tax rate is 30 percent. The expected return on the market is 14.0 percent and the risk-free rate is 4.0 percent. a. What is the expected return on Castle Hotel’s equity? b. What is the beta for Castle Hotel’s equity? Part a WACC = [(E/V) × R E ] + [(D/V) × R D × (1 – Tc)] where V = E + D WACC = .090 E = \$100 million D = \$200 million V = E + D = \$100 million + \$200 million = \$300 million R D = .090 = pre-tax cost of debt Tc = 0.30 WACC = [(E/V) × R E ] + [(D/V) × R D × (1 – Tc)] .090 = [(100m/300m) × R E ] + [(200m/300m) × .090 × (1 – .30)] = [(100m/300m) × R E ] + [(200m/300m) × .090 × .70] = [(100m/300m) × R E ] + .042 So .090 – .042 = .048 = [(100m/300m) × R E ] So R E = .048 × (300m/100m) = .144 = 14.4% Part b

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08%20cost%20of%20capital%20test%20bank%20problems%20solutions

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