Dr. Sudhakar Raju
Financial Statements Analysis
QUESTIONS ON “THE WEIGHTED AVERAGE COST OF CAPITAL - WACC”
1.) The Wind Rider Company has just issued a dividend of $2.10 per share on its
common stock. The company is expected to maintain a constant 7% growth rate on its
dividends indefinitely. If the stock sells for $40 a share, what is the company’s cost of
2.) The Ball Corporation’s common stock has a beta of 1.15. If the risk free rate is 5%
and the expected return on the market is 12%, what is Ball Corp.’s cost of equity
3.) Stock in Parrothead Industries has a beta of 1.10. The market risk premium is 8%
and T-bills are currently yielding 5.50%. Parrothead’s most recent dividend was
$2.20 per share and dividends are expected to grow at a 5% annual rate indefinitely.
If the stock sells for $32 per share, what is the best estimate of Parrothead’s cost of
4.) Holdup Bank has an issue of preferred stock with a $5 stated dividend that just
sold for $92 per share. What is the bank’s cost of preferred stock?
5.) Legend, Inc., is trying to determine its cost of debt. The firm has a debt issue
outstanding with 12 years to maturity that is quoted at 107% of face value. The issue
makes semiannual payments and has an embedded cost of 10% annually. What is
Legend’s pretax cost of debt? If the tax rate is 35%, what is the after tax cost of debt?
6.) Jiminy’s Cricket Farm issued a 30-year, 9% semi-annual bond 8 years ago. The
bond currently sells for 105% of its face value. The company’s tax rate is 35%.
a.) What is the pretax cost of debt?
b.) What is the after tax cost of debt?
7.) Mullineaux Corporation has a target capital structure of 50% common stock, 5%
preferred stock, and 45% debt. Its cost of equity is 18%, the cost of preferred stock is
6.50%, and the pre-tax cost of debt is 8%. The relevant tax rate is 35%.
a.) What is Mullineaux’s WACC?
b.) The company president has approached you about Mullineaux’s capital structure.
He wants to know why the company doesn’t use more preferred stock financing since
it costs less than debt. What would you tell the president?
8.) Modigliani Manufacturing has a target debt-equity ratio of .75. Its cost of equity
is 18% and its pre-tax cost of debt is 10%. If the tax rate is 35%, what is
9.) Fama’s Llamas has a weighted average cost of capital of 12.50%. The company’s
cost of equity is 15% and its cost of debt is 8%. The tax rate is 35%. What is Fama’s
target debt-equity ratio?
10.) Sniffles, Inc. has a target debt-equity ratio of .90. Its WACC is 13% and the tax
rate is 35%.
a.) If Sniffles’ cost of equity is 18%, what is its pretax cost of debt?
b.) If instead you know that the after tax cost of debt is 7.50%, what is the cost of
11.) Given the following information for Dunhill Power Co., find the WACC.
Assume the company’s tax rate is 35%.
a.) Debt: 3,000, 8% coupon bonds outstanding, $1000 par value, 20 years to
maturity, selling for 103% of par. The bonds make semiannual payments.
b.) Common Stock: 90,000 shares outstanding, selling for $45 per share; the beta is
c.) Preferred stock: 13,000 shares of 7% preferred stock outstanding, currently
selling for $108 per share.
d.) Market: 8% market risk premium and 6% risk-free rate
12.) Suppose your company needs $15 million to build a new assembly line. Your
target debt-equity ratio is .90. The flotation cost for new equity is 8 percent, but the
flotation cost for debt is only 5 percent.
a. Your boss has decided to fund the project by borrowing money because the
flotation costs are lower and the needed funds are relatively small. What do you think
about the rationale behind borrowing the entire amount?
b. What is your company’s weighted average flotation cost assuming that the existing
D/E ratio is preserved and all equity is raised externally (i.e. no retained earnings is
c. What is the true cost of building the new assembly line after taking flotation costs
13.) Goodbye, Inc., recently issued new securities to finance a new TV show. The
project cost $10.5 million, and the company paid $750,000 in flotation costs. In
addition, the equity issued had a flotation cost of 8 percent of the amount raised,
whereas the debt issued had a flotation cost of 3 percent of the amount raised. If
Goodbye issued new securities in the same proportion as its target capital structure,
what is the company’s target debt-equity ratio?
14.) Photochronograph Corporation (PC) manufactures time series photographic
equipment. It is currently at its target D/E (debt-equity) ratio of 0.80. It’s considering
building a new $75 million manufacturing facility. This new plant is expected to
generate after tax cash flows of $10.9 million in perpetuity. The company raises all
capital from outside financing. There are three financing options:
a.) A new issue of common stock: The flotation costs of the new common stock would
be 8 percent of the amount raised. The required return on the company’s new equity
is 17 percent.
b.) A new issue of 20-year bonds: The flotation costs of the new bonds would be 4
percent of the proceeds. If the company issues these new bonds at an annual coupon
rate of 9 percent, they will sell at par.
c.) Increased use of accounts payable financing: Because this financing is part of the
company’s ongoing daily business it has no flotation costs and the company therefore
assigns it a cost that is the same as the overall firm WACC. Management has a target
ratio of accounts payable to long-term debt of 20 percent. (Assume there is no
difference between the pretax and after tax accounts payable cost.)
The total debt of PC is made up of L-T Debt (i.e. bonds) and Accounts Payable. PC is
in the 35% tax bracket.
What is the WACC of the project? What is WAFC? What is the NPV of the project?
15.) Suppose you have been hired as a financial consultant to Defense Electronics,
Inc. (DEI), a large, publicly traded firm that is the market leader in radar detection
systems (RDSs). The company is looking at setting up a manufacturing plant
overseas to produce a new line of RDSs. The manufacturing plant will cost $30
million to build and will be situated on a parcel of land that was purchased by DEI
three years ago for $8 million. Recently, the land was appraised at a value of $10.2
million. The project will last five-years.
Reported below are data on DEI securities:
Debt: 25,000 units of 7 percent coupon bonds outstanding, 15 years to
maturity, selling for 92 percent of par; the bonds have a $1,000 par
value each and make semiannual payments.
Common 450,000 shares outstanding, selling for $75 per share; the beta is
Preferred 30,000 shares of 5 percent preferred stock outstanding, selling for
stock: $72 per share.
Market: 8 percent expected market risk premium; 5 percent risk-free rate.
DEI uses G.M. Wharton as its lead underwriter. Wharton charges DEI spreads of 9
percent on new common stock issues, 7 percent on new preferred stock issues, and 4
percent on new debt issue. Wharton has included all direct and indirect issuance
costs (along with its profit) in setting these spreads.
Assume Wharton raises all capital for this project through issuing bonds, preferred
stock and common stock while preserving its existing capital structure.. The project
requires $900,000 in initial net working capital investment to get operational. These
funds are available from internal sources and will not need to be financed. At the end
of 5 years the project is scrapped. Assume zero salvage value and ignore any
a). Calculate the project’s initial (Time 0) cash flow taking into account all side
b. The new RDS project is somewhat riskier than a typical project for DEI, primarily
because the plant is being located overseas. Management has told you to use an
adjustment factor of +2% to account for this increased riskiness. Calculate the
appropriate discount rate to use when evaluating DEI’s project.
c. The company will incur $400,000 in annual fixed costs. The plan is to manufacture
17,000 RDSs per year and sell them at $10,000 per machine; the variable production
costs are $9,000 per RDS. What is the annual operating cash flow (OCF) from this
project? (Ignore tax and depreciation effects).
d. DEI’s comptroller is primarily interested in the impact of DEI’s investments on the
bottom line of reported accounting statements. What will you tell her is the
accounting break-even quantity of RDSs sold for this project?
e. Finally, DEI’s president wants you to throw all your calculations, assumptions, and
everything else into the report of the chief financial officer; all he wants to know is
what the RDS project’s internal rate of return (IRR) and net present value (NPV) are.
What will you report?