Old Exam Questions  Cost of Capital  Solutions
Page 20 of 42 Pages
A.
8.51%
B.
9.99%
C.
9.25%
*
D.
8.88%
E.
9.62%
Determine YTM:
N = 20; PV = 1,074.39; PMT = 35; FV = 1,000; Solve for I/YR = 3.0 * 2 = 6.00% =
YTM
Aftertax K
D
= (6%)(1.40) = 3.6%
K
S
= 0.04 + (0.06)(1.4) = 12.40%
Alternatively,
g = (0.15)(1  0.40) = 9%
K
S
= $1.53 / $45.00 + 0.09 = 0.034 + 0.09 = 12.40%
K
e
= $1.53 / ($44.00)(1  0.10) + 0.09 = 12.86% (Not needed for this problem.)
Therefore, for very first dollar:
WACC = (3.6%)(0.40) + (12.40%)(0.60) = 1.44% + 7.44% = 8.88%
23.
Assume that an all equity firm has a return on assets (ROA) of 12.80 percent. And that
the firm makes the decision to replace
¼
of its equity with debt that has a beforetax
cost of 8 percent (note: this will give a D/E ratio of (
¼
/
¾
) = 1/3 ). Assuming that the
firm’s tax rate is 40 percent, calculate the firm’s ROE after the debt has been issued
and equity has been repurchased.
A.
15.10%
*
B.
15.47%
C.
14.73%
D.
15.84%
E.
14.36%
AT K
D
= (8.00%)(1.40) = 4.80%
As discussed in class, after the issue and repurchase, the remaining equity
shareholders will benefit from both a leverage effect and a tax shelter effect:
ROE = 12.80% + (12.80%  8.00%)(1/3) + (8.00%  4.80%)(1/3)
ROE = 12.80% + 1.60% + 1.07% = 15.47%
The following is an illustration with some numbers that were “pulled from the air”:
assets of $1,200, then working backwards from an ROA of 12.80% to get EBIT of
$256.00.
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Old Exam Questions  Cost of Capital  Solutions
Page 21 of 42 Pages
Assets/Income
Without
Debt
With
Debt
Assets
$1,200.00
$1,200.00
Debt (1/4)
$ 0.00
$ 300.00
Equity
$1,200.00
$ 900.00
EBIT
$ 256.00
$ 256.00
Interest (8%)
$ 0.00
 $ 24.00
EBT
$ 256.00
$ 232.00
Taxes (40%)
 $ 102.40
 $ 92.80
Net Income
$ 153.60
$ 139.20
ROA
12.80%
11.60%
ROE
12.80%
15.47%
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 Spring '08
 Staff
 Cost Of Capital, Dividend yield, Weighted average cost of capital, Old Exam Questions, capit al structure

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