The Cost of Capital
1. Midwest Water Works estimates that its WACC is 10.5%. The company is considering the
following capital budgeting projects:
Project Size Rate of Return
A $1 million 12.0%
B $1 million 10.2%
C $1 million 11.2%
D $2 million 9.8%
E $2 million 11.0%
F $2 million 10.0%
G $1 million 11.4%
If you assume that each of these projects is just as risky as the firm's existing assets, and the firm
may accept all the projects or only some of them, which set of projects should be accepted?
a. A, B, C & D b. A, C, E & G c. A, D, E, F & G d. A, B, D, E & G
2. A firm's capital structure consists of $112,500 in bonds, $187,500 in common stock, and $75,000 in
preferred stock. If the cost of capital is 8%, 10%, and 6% for bonds, common stock, and preferred
stock respectively, what is the weighted average cost of capital (WACC)? (Choose the closest
answer provided).
a. 8.6% b. 8.0% c. 7.4% d. 7.7%
3. A firm is issuing new common stock at a price of $50. Dividends last year were $2.00 and are expected
to grow at an annual rate of 6% forever. Flotation costs will be 5% of the issue price. What is this
firm's cost of equity? (Choose the closest answer provided).
a. 10.5% b. 10.2% c. 11.2% d. 11.6%
4. A firm is considering a new investment to be financed partially with debt. The firm can sell new
$1,000 par value bonds with a coupon rate of 11% that will mature in 18 years. The firm is in a 30%
tax bracket and flotation costs would be 3%. What is their cost of capital if they decide to issue the
new bonds?
a. 7.3% b. 8.0% c. 9.4% d. 11.4%
5. In question #4 above, what is the investor's required rate of return?
a. 8.0% b. 11.0% c. 11.4% d. 8.5%. A firm's cost of capital for newly issued bonds is 8.4% and the investor's required rate of
return on these bonds is 10%. Specifically, which of the following explains (accounts for) the
difference between these two values?
I. Taxes II. Investor's Risk Tolerance III. Flotation Costs
a. I only b. II only c. III only d. I and III e. I, II, and III
Use the following information to answer questions #7 thru #9 below:
Hudson Corp.'s common stock now sells for $20.00 per share and last year's dividend was $1.00.
This dividend is expected to grow by 8% per year. If new common stock is issued, Hudson will
pay $1.20 per share in flotation costs.
7. What is the investor's required rate of return on Hudson's common stock?
a. 12.8% b. 13.4% c. 13.7% d. 13.0%
8. What is Hudson's cost of capital if they issue new common stock?
a. 12.8% b. 13.4% c. 13.7% d. 13.0%
9. What is Hudson's cost of Retained Earnings?
a. 12.8% b. 13.0% c. 13.7% d. 13.4%
10. Sampson Industries can issue perpetual preferred stock at a price of $26.80 per share. The stock would
pay a constant annual dividend of $1.50 a share. What is the investor's required rate of return on this
preferred stock?
a. 5.3% b. 7.2% c. 6.0% d. 5.6%
Formulas:
D
Cost of Preferred Stock: k = ------------------------------------------
(Net Proceeds from Sale of Stock)
D1
Cost of Common Stock: k = ----------------------------------------- + g
(Net Proceeds from Sale of Stock)
D1
Cost of Retained Earnings: k = ------------------------ + g
Sale Price of Stock