A 7% coupon bond issued by the state of New York sells for $1,000 and thus provides a7%

yield to maturity. For an investor in the 40% tax bracket, what coupon rate on aCarter
Chemical Company bond that also sells at its $1,000 par value would cause thetwo bonds to
provide the investor with the same after-tax rate of return?

ANSWER: 11.67%

The Textbook Production Company has been hit hard due to increased competition. The
company's analysts predict that earnings (and dividends) will decline at a rate of 5 percent
annually forever. Assume that rs = 11 percent and D0 = $2.00. What will be the price of the
company's stock three years from now?

Equation solution:
D4= $2.00*(0.95)^4 = $1.629

Calculate expected price of stock, P3, at time = 3

P3=D4/(r-g)=$1.629/(0.11-(-0.05))=$10.18

IBM is currently selling at $65 per share.Next year's dividend is expected tobe $2.60.If
investors on this particular day expect a return of 12% on their investment, what dothey
think IBM's growth rate will be?

ANSWER: 8 percent

The Satellite Building Company has fallen on hard times. Its management expects to pay
no dividends for the next 2 years. However, the dividend for Year 3, D3, will be $1.00 per
share, and the dividend is expected to grow at a rate of 3 percent in Year 4, 6 percent in
Year 5, and 10 percent in Year 6 and thereafter. If the required return for Satellite is 20
percent, what is the current equilibrium price of the stock?"

ANSWER: $6.34

Your brother-in-law, a stockbroker at Invest, Inc., is trying to sell you a stock with
acurrent market price of $20.The stock had a last dividend (D0) of $2.00 and a
constantgrowth rate of 8%.Your required return on this stock is 20%.From a strict
valuationstandpoint, you should:

Not buy the stock;it is overvalued by $2.00.

Negative Limited is expected to grow for four years at a rate of 50 percent.After fouryears,
the product fad is expected to decline, and Negative will grow at a negativegrowth rate of 5
percent.Negative currently pays a dividend of $1.00 per share andstockholders have a
required rate of return of 18 percent.What should be the marketvalue for a share of
Negative Limited stock?

ANSWER:$18.34

Assume the firm has been growing at a 15% annual rate and is expected to continue to do
so for 3 more years. At that time, growth is expected to slow to a constant 4% rate. The
firm maintains a 30% payout ratio, and this year's retained earnings were $1.4 million.
The firm's beta is 1.25, the risk-free rate is 8%, and the market risk premium is 4%. If the
market is in equilibrium, what is the market value of the firm's common equity (1 million
shares outstanding)?

ANSWER: $9.16 million

Firm valuation

Time line:
ks = 13%
0 1 gS = 15% 2 gS = 15% 3 gn = 4% 4 years
gs = 15%

D0 = ? = 0.60 D1 = 0.69 D2 = 0.794 D3 = 0.913 D4 = 0.950

P 0 = ?
0.611 0.950
0.622 P̂3   10.556
0.633
0.13  0.04
7.316
P 0 = $9.182

Calculate required rate of return

ks = 8% + (4%)1.25 = 13.0%.
Calculate net income, total dividends, and D0
Net income = $1.4 million/(1 - payout ratio)
= $1.4 million/0.7 = $2.0 million.
Dividends = $2.0 million 0.3 = $0.6 million.
D0 = $600,000/1,000,000 shares = $0.60.

Financial calculator solution:

Inputs: CF0 = 0; CF1 = 0.69; CF2 = 0.794; CF3 = 11.469; I = 13.
Output: NPV = $9.18. P̂ = P0 = $9.18.
0

Total market Shares

value = P0 outstanding = $9.18 1,000,000 = $9,180,000.
Suppose the following bond quote for the Beta Company appears in the financial page of
today's newspaper. Assume the bond has a face value of $1,000 and the current date is
April 15, 2009. What is the yield to maturity on this bond?

This cannot be solved directly, so it's easiest to just use the calculator method to get an
answer. You can then use the calculator answer as the rate in the formula just to verify that
your answer is correct.

The bulldog Company paid $1.5 of dividends this year. If it's dividends are expected to
grow at a rate of 3 percent per year, what is the expected dividend per share for bulldog
four years from today?

D4 = D0 (1 + g)^4
= $1.5 (1 + 0.03)^4
= 1.69
The Hatch Sausage Company is projecting an annual growth rate for the foreseeable
future of 9%. The most recent dividend paid was $3.00 per share. New common stock can
be issued at $36 per share. Using the constant growth model, what is the approximate cost
of capital for retained earnings?

ANSWER: 18.08%

Angela Company's capital structure consists entirely of long-term debt and common
equity. The cost of capital for each component is shown below. Long-term debt 8%
Common equity 15% Angela pays taxes at a rate of 40%. If Angela's weighted average cost
of capital is 10.41%, what proportion of the company's capital structure is in the form of
long-term debt?

ANSWER: 45%

The effective rate for Angela’s debt is the after-tax cost [8% ×(1.0 – .40 tax rate) = 4.8%].
The formula for weighted-average cost of capital can besolved as follows: (Debt weight ×
Cost of debt) + (Equity weight × Cost of equity) =WACC (Debt weight ×.048) + (Equity
weight × .15) = .1041 [(1 – Equity weight) ×.048] + (Equity weight × .15) = .1041 .048 – (.048
× Equity weight) + (Equity weight× .15) = .1041 – (.048 × Equity weight) + (Equity weight ×
.15) = .0561 Equityweight × .102 = .0561 Equity weight = .55 Since equity is 55% of the
capitalstructure, debt makes up 45%

A firm's new financing will be in proportion to the market value of its current financing
shown below.
Carrying Amount

($000 Omitted)

Long-term debt $7,000

Preferred stock (100,000 shares) 1,000

Common stock (200,000 shares) 7,000

The firm's bonds are currently selling at 80% of par, generating a current market yield of
9%, and the corporation has a 40% tax rate. The preferred stock is selling at its par value
and pays a 6% dividend. The common stock has a current market value of $40 and is
expected to pay a $1.20 per share dividend this fiscal year. Dividend growth is expected to
be 10% per year, and flotation costs are negligible. The firm's weighted-average cost of
capital is (round calculations to tenths of a percent)
The first step is to determine the component costs of each form of capital. Multiplying the
current yield of 9% (since the coupon rate is not given) times one minus the tax rate (1.0 -
.40 = .60) results in an after-tax cost of debt of 5.4% (9% × .60). Since the preferred stock is
trading at par, the component cost is 6% (the annual dividend rate). The component cost of
common equity is calculated using the dividend growth model, which combines the
dividend yield with the growth rate. Dividing the $1.20 dividend by the $40 market price
produces a dividend yield of 3%. Adding the 3% dividend yield and the 10% growth rate
gives a 13% component cost of common equity.

Once the costs of the three types of capital have been computed, the next step is to weight
them according to their current market values. The market value of the long-term debt is
80% of its carrying amount, or $5,600,000 ($7,000,000 × 80%). The $1,000,000 of preferred
stock is selling at par. The common stock has a current market value of $8,000,000 (200,000
shares × $40).

Long-term debt $ 5,600,000 × 5.4% = $ 302,400

Preferred stock 1,000,000 × 6.0% = 60,000

Common stock 8,000,000 × 13.0% = 1,040,000

Totals $14,600,000 $1,402,400

Thus, the weighted-average cost of capital is 9.6% ($1,402,000 ÷ $14,600,000)

Anderson Company has four investment opportunities with the following costs (paid at t =
0) and expected returns:
Expected
Project Cost Return
A $2,000 16.0%
B 3,000 14.5
C 5,000 11.5
D 3,000 9.5

The company has a target capital structure that consists of 40 percent common
equity, 40 percent debt, and 20 percent preferred stock. The company has $1,000 in
retained earnings. The company expects its year-end dividend to be $3.00 per share
(D1 = $3.00). The dividend is expected to grow at a constant rate of 5 percent a year.
The company’s stock price is currently $42.75. If the company issues new common
stock, the company will pay its investment bankers a 10 percent flotation cost.
 The company can issue corporate bonds with a yield to maturity of 10 percent. The
company is in the 35 percent tax bracket. How large can the cost of preferred stock
be (including flotation costs) and it still be profitable for the company to invest in all
four projects?
We need to find kp at the point where all 4 projects are accepted. In other words, the
capital budget = $2,000 + $3,000 + $5,000 + $3,000 = $13,000. The WACC at that point is
equal to IRRD = 9.5%.

Step 1:Find the retained earnings break point to determine whether ks or ke is used in the
WACC calculation:

$1,000
BPRE = 0.4 = $2,500.

Since the capital budget > the retained earnings break point, ke is used in the WACC
calculation.

Step 2:Calculate ke:

$3.00
ke = + 5% = 12.80%.
$42.75(0.9)

Step 3:Find kp:

9.5% = 0.4(10%)(0.65) + 0.2(kps) + 0.4(12.80%)

9.5% = 2.60% + 0.2(kps) + 5.12%

1.78% = 0.2kp

8.90% = kp.

J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10
percent preferred stock, and 50 percent common equity. The firm's current after-tax cost
of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's
preferred stock currently sells for $90 a share and pays a dividend of $10 per share;
however, the firm will net only $80 per share from the sale of new preferred stock. Ross
expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells
for $40 per share, but the firm will net only $34 per share from the sale of new common
stock. The firm recently paid a dividend of $2 per share on its common stock, and investors
expect the dividend to grow indefinitely at a constant rate of 10 percent per year.

51. Refer to J. Ross and Sons Inc. What is the firm's cost of retained earnings?
rs =($20.00(1.10))/$40.00+0.10=15.5%

52. Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued common stock?

re =$2.20/$34.00+0.10=16.5%

53. Refer to J. Ross and Sons Inc. What is the firm's cost of newly issued preferred stock?

rps =$10/$80=12.5%

54. Refer to J. Ross and Sons Inc. Where will a break in the WACC curve occur?

Breakpoint = $15,000/0.50=$30,000

55. Refer to J. Ross and Sons Inc. What will be the WACC above this break point?

WACC = 6%(0.40) + 12.5%(0.10) + 16.5%(0.50) = 11.90%.

Medical Research Corporation is expanding its research and production capacity to

introduce a new line of products. Current plans call for the expenditures of $100 million on
four projects of equal size ($25 million each), but different returns. Project A is in
antiblood-clotting proteins and has an expected return of 18%. Project B relates to a
hepatitis vaccine and carries a potential return of 14%. Project C dealing with a
cardiovascular compound, is expected earn 11.8%, and Project D, an investment in
orthopedic implants, is expected to show a 10.9% return. The firm has $15 million in
retained earnings. After a capital structure with $15 million in retained earnings is reached
(in which retained earnings represents 60 % of the financing), all additional equity
financing must come in the form of new common stock. Common stock is selling for $25
per share and underwriting costs are estimated at $3 if new shares are issued. Dividends
for the next year will be 90 cents per share D1), and earnings and dividends have grown
consistently at 11% per year. The yield on comparative bonds has been hovering at 11%.
The investment banker feels that the first $20 million of bonds could be sold to yield 11%
while additional debt might require a 2% premium and be sold to yield 13%. The
corporate tax rate is 30%. Debt represents 40% of the capital structure.

a). Based on the two sources of financing, what is the initial weighted average cost of
capital? (use Kd and Ke)

. b). At what size capital structure will the firm run out of retained earnings?
c). What will the marginal cost of capital be immediately after that point?

d). At what size capital structure will there be a change in the cost of debt?

e). What will the marginal cost of capital be immediately after that point?

f). Based on the information about potential returns on investments in the first paragraph
and information on marginal cost of capital ( in parts a, c, and e) how large a capital
investment budget should the firm use?

g). Graph the answer to determine in part f.

Solution:
Marginal Cost of
Capital and Investment Returns

Medical Research Corporation

a. Kd = Yield (1 – T)
= 11% (1 – .30) = 11% (.70) = 7.70%

Ke = (D1/Po) + g
= ($.90/$25.00) + 11.0% = 3.6% + 11.0% = 14.60%

Cost Weighted
(aftertax) Weights Cost
Debt (Kd) ....................................................... 7.70% 40% 3.08%
Common equity (Ke)
(retained earnings) ..................................... 14.60 60 8.76
Weighted average cost
of capital (Ka).............................................. 11.84%

Retained earnings
b. X 
% of retained earnings in the capital structure

$15 million
  $25 million
.60
c. First compute Kn
 Kn = (D1/(Po – F)) + g
= ($.90/($25 – $3)) + 11%
= ($.90/$22) + 11% = 4.09% + 11% = 15.09%

Cost Weighted
(aftertax) Weights Cost
Debt (Kd) ....................................................... 7.70% 40% 3.08%
New common stock
(Kn) .............................................................. 15.09 60 9.05
Marginal cost of capital
(Kmc) ............................................................ 12.13%

Amount of lower cost debt

d. Z 
% of debt in the capital structure

$20 million
  $50 million
.40
e. First compute the new value for Kd
Kd = Yield (1 – T)
= 13% (1 – .30) = 13% (.70) = 9.10%

Cost Weighted
(aftertax) Weights Cost
Debt (Kd) ....................................................... 9.10% 40% 3.64%
New common stock
(Kn) .............................................................. 15.09 60 9.05
Marginal cost of capital
(Kmc) ............................................................ 12.69%

f. The answer is $50 million.

Return on Marginal Cost of

Investment Capital
1st $25 million 18.0% > 11.84%
$25 million - $50 million 14.0% > 12.13%
$50 million - $75 million 11.8% < 12.69%
$75 million - $100 million 10.9% < 12.69%
g. Top bar represents return on investment
Dotted line represents marginal cost of capital (Kmc)
Invest up to $50 million

Percent (return)
18%

14%
12.69% Kmc

12.13%

11.8% 11.84%

10.9%

0 25 50 75 100

Amount of Capital ($ millions)

THEORIES:

The additional return offered by a more risky investment relative to a safer one is called

a.the risk-free rate

b.the risky return.

c.the risk premium.

d.the insurance premium.

If we are able to eliminate all of the unsystematic risk in a portfolio then, what is the
result?

a risk-free portfolio
a portfolio that contains only systematic risk

a portfolio that has an expected return of zero

such a portfolio cannot be constructed since there will always be unsystematic risk in any
portfolio

According to the Capital Asset Pricing Model, the security market line is a straight line.
The intercept of this line should be equal to:
A. Zero
B. The expected risk premium on the market portfolio
C. The risk-free rate

Which of the following would cause a bond’s required return to increase?

Call provision

Which of the following causes a lower required return on a bond?

The bond is convertible

If dividends on a common stock are expected to grow at a constant rate forever, and if you
aretold the most recent dividend paid, the dividend growth rate, and the appropriate
discount ratetoday, you can calculate ___________.

I.the price of the stock today

II.the dividend that is expected to be paid ten years from now
III.the appropriate discount rate ten years from now

A)I only
B)I and II only
C)I and III only
D)II and III only
E)I, II, and III

OldTime, Inc., is a mature firm operating in a very stable market. Earnings growth has
averaged about 3.2% for the last dozen years, just staying in line with inflation. The firm's
weighted-average cost of capital is 8%, much lower than most firms. John Storms has just
been hired as OldTime's new CEO and wants to turn what he calls a "cash cow" into a
"growth company." Storms wants to reduce the dividend pay-out and use the resulting
retained earnings to fund the firm's expansion into new product lines. OldTime's historical
beta has been about 0.6. With the CEO's changes, what will most likely happen to
OldTime's beta and the required return on investment in its shares?

The beta will rise, and the required return will rise.

An investor is currently holding income bonds, debentures, subordinated debentures, and

first-mortgage bonds. Which of these securities traditionally is considered to have the least
risk?

First-mortgage bonds.

Scholastic Toys is considering developing and distributing a new board game for children.
The project is similar in risk to the firm's current operations. The firm maintains a debt-
equity ratio of 0.40 and retains all profits to fund the firm's rapid growth. How should the
firm determine its cost of equity?

A. by adding the market risk premium to the aftertax cost of debt

B. by multiplying the market risk premium by (1 - 0.40)
C. by using the dividend growth model
D. by using the capital asset pricing model
E. by averaging the costs based on the dividend growth model and the capital asset pricing
model

Refer to the following data for a particular commercial bank:

Tier I Capital $7.6 billion
Total Risk-based Capital $ 8.6 billion
Total Assets $84 billion
Earning Assets $75 billion
Total Risk-Adjusted Assets $71 billion
Compute the bank's total risk-based capital ratio
ANSWER: .121