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Cost of Capital Practice Problems

# Cost of Capital Practice Problems - Problem 1 Amalgated...

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Problem 1 Amalgated Properties Limited (APL) needs \$2,000,000 for it’s capital budget projects this year. APL has the following capital structure, which it considers optimal (based on market values). Debt 20% Preferred Shares 15% Common Shares 65% APL has \$1,000 par value bonds outstanding with a 9% coupon rate and 8 years to maturity. Issusing costs would be \$20 per bond and the bonds could be sold at a discount of \$30 per bond. Preferred shares with a \$80 par value could be sold to the public at a price of \$75 per share and s dividend of 10%, however flotation costs would be \$2 per share. APL paid a dividend of \$4 per share last year and earnings and dividends are expected to grow at a constant rate of 8% per year. APL’s stock currently sells at a price of \$65 per share and after-tax flotation costs would be \$2 per share. APL has a marginal tax rate of 40% and this year, they expect to have \$1,200,000 available from internally generated funds available for capital budgeting purposes. Calculate APL’s marginal cost of capital (WACC). Problem 2 A firm currently has \$10 million (par value) in debt outstanding in the form of bonds, which currently trade at 104% of par value. The bonds have a remaining term to maturity of 7 years. They have a coupon rate of 10%. The firm also has preferred shares outstanding; they have 1 million preferred shares outstanding, which pay an annual dividend of \$0.40 each. The current market price of the firm’s preferred is \$5. The firm has 2 million common shares outstanding which trade at a price of \$12 each. The firm’s common shares have a correlation with the overall stock market of 0.35. The standard deviation of returns on the firm’s stock is 0.4, and for the market overall the standard deviation is 0.1. The yield on Treasury bills is 4% and the expected risk premium on the market is 5.5%. To issue new bonds would involve flotation costs (after tax) equal to 2% of the par value issued. To issue new shares (whether preferred or common) would involve flotation costs equal to 5% of the current price. The firm has enough cash on hand to finance any projects which it wants to, and its tax rate is 34%. (a) What is the weighted average cost of capital of the firm? (b) Assume that there is a change in the investment environment, and investors suddenly start believing that the stock market is riskier than they thought it was before. Because of this, the risk premium on the market increases. How and why might this affect the firm’s investment decisions (i.e. what projects they decide to invest in)? Problem 3 A firm is financed with a combination of debt and common equity. The market value of the firm’s debt is \$150 million. The yield to maturity of the firm’s debt is 12%. The firm has 20 million common shares outstanding, with a total market value of \$500 million. It 1

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is expected that next year’s dividend on the shares will be \$3 and that dividends will grow at a rate of 4% per year after that. To borrow new money would involve no flotation
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Cost of Capital Practice Problems - Problem 1 Amalgated...

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