chapter 1 spreadsheet basics - leeds school of …leeds-faculty.colorado.edu/donchez/fnce...

CHAPTER 10: COST OF CAPITAL

Instructor’s Manual Problem Set

1. The Claustrophobic Solution, Inc., a residential window and door manufacturer, has the following historical record of earnings per share (EPS) from 2011 to 2007:

2011 2010 2009 2008 2007EPS $1.10 $1.05 $1.00 $0.95 $0.90

The company’s payout ratio has been 60% over the last five years and the last quoted price of the firm’s share of stock was $10. Flotation costs for new equity will be 7%. The company has 30,000,000 of common shares of stock outstanding and a debt-equity ratio of 0.5.

a. If dividends are expected to grow at the same arithmetic average growth rate of the last five years, what is the dividend payment in 2012?

Worksheet:

Formulas:

453

b. Calculate the firm’s cost of retained earnings and the cost of new common equity.

Worksheet:

Formulas:

c. Calculate the break-point associated with retained earnings.Worksheet:

Formulas:

454

CHAPTER 10: COST OF CAPITALIM Problem Set & Solutions

d. If the Claustrophobic Solution’s after-tax cost of debt is 9%, what is the WACC with retained earnings? With new common equity?

Worksheet:

Formulas:

2. Black Diamond, Inc., a manufacturer of carbon and graphite products for the metal production, electronics, aerospace and transportation industries, is considering several funding alternatives for an investment project. To finance the project, the company can sell 1,000 15-year bonds with a $1,000 face value, 7% coupon rate. The bonds require an average discount of $50 per bond and flotation costs of $40 per bond when being sold. The company can also sell 5,000 preferred stocks that will pay a $2 dividend per share at a price of $40 per share. The cost of issuing and selling preferred stocks is expected to be $5 per share. To calculate the cost of common stock, the company uses the dividend discount model. The firm just paid a dividend of $3 per common share. The company expects this dividend to grow at a constant rate of 3% per year indefinitely. The flotation costs for issuing new common shares of stock are 7%. The company plans to sell 10,000 shares at a price of $50 per share. The company's tax rate is 40%.

a) Calculate the company's after-tax cost of long-term debtb) Calculate the Company's cost of preferred stockc) Calculate the company's cost of common stockd) Calculate the company's weighted average cost of capital

Worksheet:

455


Formulas:

e) What would be the company's weighted average cost of capital without flotation costs?

Worksheet:

456


Formulas:

3. Hard Structures, Inc., a manufacturer of steel wire reinforcements and pre-stressed concrete strands for the concrete construction industry, wants to determine its WACC. Today 1/1/2012 the firm issued 7000 bonds that will mature in 1/1/2032 with $1,000 face value. These bonds will pay a 9% coupon rate semiannually and are currently selling for $950. The firm has 100K preferred shares of stock outstanding with a book value of $40, but currently selling for $50 per share. The last preferred and common dividend payments were $3.5 and $2.5 per share respectively. The firm’s EPS five years ago was $8.00 and the firm expects to increase its next dividend payment by the implied 5-year earnings per share (EPS) growth rate. Flotation costs on debt and preferred equity (D&P) are both 3%, but 7% in the case of common stocks. The common stock is selling today for $25 and the firm’s tax rate and payout ratio are 40% and 25% respectively. The firm has 200K shares of common stock outstanding with the same book value as that of its preferred stock.

457


a. Calculate the book value and market value weights for each source of capital.

Worksheet:

Formulas:

458


b. Calculate the component costs of capital (i.e., debt, preferred equity, retained earnings, and new common equity)

Worksheet:

Formulas:

c. Determine the weighted average costs of capital using both the market and the book value weights.

Worksheet:

459


Formulas:

4. Suppose the firm in the previous problem has estimated raising new funds in the capital markets under the following conditions:

Source Range After-tax CostRetained Earnings Up to 500,000 Solution Problem #3Common Equity Up to 2,000,000 Solution Problem #3

2,000,001 to 5,000,000 17.00%More than 5,000,000 19.00%

Preferred Equity Up to 500,000 Solution Problem #3More than 500,000 8.50%

Debt Up to 2,000,000 Solution Problem #32,000,001 to 5,000,000 7%More than 5,000,000 9%

a. Using this information, calculate each of the break-points.

Worksheet:

460


Formulas:

b. Create a chart of TRM’s marginal WACC curve using the market value weights. Make sure that it is a perfect step function.

Worksheet:

461


Formulas

462


0 200,000 400,000 600,000 800,000 1,000,000 8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%Marginal WACC Curve for RMM

$ Total Capital

WAC

C (%

)

5. Readable Materials Inc., a manufacturer of coated freshet and coated ground-wood paper used in catalogs, magazines and commercial printing applications, has three issues on bonds outstanding. The following table describes these issues:

Issue A Issue B Issue CPrice $850.00 $1,150.00 $900.00Face Value $1,000.00 $1,000.00 $1,000.00Coupon Rate 7.00% 11.00% 9.00%Frequency Semiannually Annually QuarterlyMaturity (Years) 15 20 30

463


Bonds 1000 2000 3000

In addition, the firm’s 100K preferred shares of stock pay $0.75 per share quarterly and currently have a market price of $30 per share and a book value of $20 per share. The flotation costs for debt, preferred, and common equity are 3%, 5%, and 7% respectively. The current price per share of the firm’s 200K common stocks is $50, but they have book value of $30 per share. The firm expects an average common dividend growth rate of 3% indefinitely and a dividend yield of 12% for the next year. The firm’s beta coefficient is 1.5 and its marginal tax rate is 40%. If the current risk free rate and market risk premium are 3% and 7% respectively, answer the following:

a. What are the book and market value weights for each source of capital?

Worksheet:

464


Formulas:

465


b. What are the component costs of capital? (i.e., debt, preferred equity, retained earnings, and new common equity.) Use the weighted average of the bond market values to determine the cost

466


of debt and the arithmetic average of the dividend discount model and CAPM model for the cost of retained earnings.

Worksheet:

Formulas:

c. What is the weighted average cost of capital using both the market and book value weights?

Worksheet:

Formulas:

467


6. Metallic Engineering, Inc., a manufacturer of fabricated aluminum products for aerospace, engineering, automotive, and custom industrial applications, is calculating its WACC. The firm’s common stock just paid a dividend of $1.5 per share and now is selling for $30. The firm’s financial staff estimates the company’s new product will generate an unusual high dividend growth rate of 17% for four years. After this period of time, the dividend growth rate will decline to 3% during a transition period of 3 years, rather than instantaneously. The firm’s debt-to-equity ratio is 3/4 and the flotation costs for new equity will be 7%. Also, the firm has a payout ratio of 60% and 20M of common shares of stock outstanding. a. Based on the information above determine the firm’s estimated retained earnings and the associated break-point.

Worksheet:

Formulas:

468


b. Calculate the firm’s cost of retained earnings and the cost of new common equity. (Hint: use the required rate of return kCS derived from the three-stage growth common stock formula in

chapter #8 as follows: kCS=g2+D0

V CS[ (1+g2 )+

n1+n2

2 ( g1−g2 )]Worksheet:

Formulas:

c. If Metallic Engineering, Inc.’ after-tax cost of debt is 5%, determine the WACC with retained earnings and new common equity.

Worksheet:

469


Formulas:

470


Test Bank

1. What should be the correct formulas for cells B2 and B3?a. =B1/(1-B1) and =1/(1-B1)b. =B1/(1+B1) and =1/(1+B1)c. =B1/(1+B1)^2 and =1/(1+B1)^2d. =B1/(1-B1)^2 and =1/(1-B1)^2e. =B1/(B1-1) and =1/(B1-1)Solution: b.

2. What should be the correct formula for cell B5? (Hint: express the weight of equity and 100% less the weight of debt and solve for this variable out of this equation: B1 = [(1 − x) × B2] + [x × B3 × (1 – B4)]a. =(B1-B2/B4)*(B1 - B3*B4)b. =B1-B2/B3-B2 - B3*B4c. =(B2+B3-B4*B1)/(B3+B2 + B3*B4)d. =(B1+B2-B3)/( B2 - B3*B4)e. =(B1-B2)/(B3-B2 - B3*B4)Solution: e.

3. What should be the correct formula for cell B5?a. =B2/(1-B1)+B3*B4*B1/(1-B1)b. =B2/(1+B1)+B3*(1-B4)*B1/(1+B1)c. =B2/(1+B1)+B3*B1/(1+B1)d. =B2/(1-B4)+B3*B1/(1-B4)e. =B2/(1-B1)+B3/(1-B1)

Solution: c.

471


4. What should be the correct formula for cell B10?

a. =B2*B8/(B2*B8+B1*B7+B3*B5)b. =B2*B6/B2*B6+B1*B7+B3*B5c. =B2*B8/(B2*B8+B1*B9+B3*B4)d. =B2*B6/(B2*B6+B1*B7+B3*B5)e. =B2*B6/(B2*B6+B1*B7)Solution: d.

5. What should be the correct formula for cell B7?a. =(B3*(1-B4)-B1*B6)/B4b. =(B5*(1-B4)-B2*B6)/B5c. =B5*(1-B4)+B2*B6/B5d. =(B5-B4-B2*B6)/B5e. =B5*(1+B4)-B3/B5

Solution: b.

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6. What would be the value of cell B6?

a. 240,000b. 320,000c. 450,000d. 150,000e. 630,000Solution: a.

7. What should be the correct formula for cell B7 if you want to find the average cost of retained earnings using both the dividend growth model and the CAPM model?a. =((B2/B3+B1)+(B5+B4*(B6-B5)))/2b. =((B3/B2+B1)+(B5-B4*B6))/2c. =((B2/B3+B1)+(B5+B4*B6))/2d. =(B2/B3+B1+B5+B4*B6)/2e. =((B3/B2-B1)-(B5-B4*B6))/2Solution: c.

8. What should be the correct formula for cell B6?a. =B5*(1-B3)/B4b. =B5*(1-B4)/B3c. =B5*B4/B3d. =B5*B3/B4e. =B5*(1-B3)/B2

Solution: b.

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9. What should be the correct formula for cell B6?

a. =B3*B2*B4+C4*C3*C2+D4*D3*D2/B3*B2+C3*C2+D3*D2b. =(B3*B2*B4-C4*C3*C2-D4*D3*D2)/(B3*B2-C3*C2-D3*D2)c. =(B4+C4+D4)*(B2*B3+C3*C2+D3*D2)/(B3*B2+C3*C2+D3*D2)d. =(B3*B2*B4+C4*C3*C2+D4*D3*D2)/(B3*B2+C3*C2+D3*D2)e. =((B3*B2+C3*C2+D3*D2)/(B3*B2+C3*C2+D3*D2))*(B4+C4+D4)Solution: d.

10. What should be the correct formula for cell B6?a. =(B1-B5+B2*B5-B2*B4)/(B3-B5)b. =(B1+B5-B2*B5+B2*B4)/(B3+B5)c. =B1-B5+B2*B5-B2*B4/B3-B5d. =(B2-B3+B1*B4-B3*B2)/(B5-B2)e. =(B1*B5/B2+B5/B2+B4)-(B3/B5)

Solution: a.

11. What should be the correct formulas for cell B4?a. =B2/(1+B3)+B3*B1/(B3+1)b. =B1/B3+B2/B3c. =B1/(1+B3)+B3*B2/(B3+1)d. =B1/(1-B3)+B3*B2/(B3-1)e. =B1*(1+B3)+B3/B2/(B3+1)Solution: c.

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12. What should be the correct formulas for cell B4?a. =(B1-B3)*(B3-B2)b. =(B1+B3)/(B3+B2)c. =(B1-B3)/(B3+B2)d. =(B1+B3)/(B3-B2)e. =(B1-B3)/(B3-B2)Solution: e.

13. What should be the correct formula for cell B5?a. =(B4+B3*B1)/((1-B3)*(1-B2))b. =(B4-B3*B1)/((1-B3)*(1-B2))c. =(B4-B3*B1)/(1-B3)*(1-B2)d. =(B4-B3*B1)/(1-B3)/(1-B2)e. =(B4+B3*B1)/((1+B3)*(1+B2))Solution: b.

14. What should be the correct formula for cell B4?a. =B3*B1+B2*(1-B3)b. =B3*B1+B2*(1+B3)c. =B3*B1-B2*(1-B3)d. =B3/B1+B2/(1-B3)e. =B3*B1-B2*(1+B3)Solution: a.

15. What should be the correct formula for cell B7?a. =B1/B2+B4/B5+B3/(1-B6)/(1-B2-B5)b. =B1*B2+B4*B5+B3*(1-B6)*(1-B2-B5)c. =B1*B2+B4*B5+B3*(1+B6)*(1+B2+B5)d. =B1*B2+B4*B5+B3/(1-B6)/(1-B2-B5)e. =B1*B2-B4*B5-B3*(1-B6)*(1-B2-B5)

Solution: b.

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chapter 1 spreadsheet basics - leeds school of …leeds-faculty.colorado.edu/donchez/fnce...

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