Barry’s Steroids Company has $1,000 par value bonds outstanding at 13 percent interest. The bonds will mature in 50 years.

If the percent yield to maturity is 11 percent, what percent of the total bond value does the repayment of principal represent? Assume interest payments are annual. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. **(Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)**

Refer to Table 10-1, which is based on bonds paying 10 percent interest for 20 years. Assume interest rates in the market (yield to maturity) decline from 12 percent to 10 percent.

**a. **What is the bond price at 12 percent?

**b. **What is the bond price at 10 percent?

**c. **What would be your percentage return on investment if you bought when rates were 12 percent and sold when rates were 10 percent? **(Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)**

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 30-year life when issued and the annual interest payment was then 14 percent. This return was in line with the required returns by bondholders at that point as described below:

Real rate of return

3

%

Inflation premium

6

Risk premium

5

Total return

14

%

Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 25 years remaining until maturity.

Compute the new price of the bond. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. **(Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)**

Katie Pairy Fruits Inc. has a $3,500 14-year bond outstanding with a nominal yield of 16 percent (coupon equals 16% × $3,500 = $560 per year). Assume that the current market required interest rate on similar bonds is now only 12 percent. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

**a. **Compute the current price of the bond. **(Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)**

**b. **Find the present value of 4 percent × $3,500 (or $140) for 14 years at 12 percent. The $140 is assumed to be an annual payment. Add this value to $3,500. **(Do not round intermediate calculations. Round your final answer to 2 decimal places. Assume interest payments are annual.)**

Lance Whittingham IV specializes in buying deep discount bonds. These represent bonds that are trading at well below par value. He has his eye on a bond issued by the Leisure Time Corporation. The $1,000 par value bond pays 8 percent annual interest and has 17 years remaining to maturity. The current yield to maturity on similar bonds is 11 percent. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

**a. **What is the current price of the bonds?

**b. **By what percent will the price of the bonds increase between now and maturity? **(Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)**

You are called in as a financial analyst to appraise the bonds of Olsen’s Clothing Stores. The $1,000 par value bonds have a quoted annual interest rate of 8 percent, which is paid semiannually. The yield to maturity on the bonds is 10 percent annual interest. There are 20 years to maturity. Use Appendix B and Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods.

**a. **Compute the price of the bonds based on semiannual analysis. **(Do not round intermediate calculations. Round your final answer to 2 decimal places.)**

**b. **With 15 years to maturity, if yield to maturity goes down substantially to 6 percent, what will be the new price of the bonds? **(Do not round intermediate calculations. Round your final answer to 2 decimal places.)**

BioScience Inc. will pay a common stock dividend of $6.80 at the end of the year (*D*1). The required return on common stock (*Ke*) is 15 percent. The firm has a constant growth rate (g) of 5 percent.

Compute the current price of the stock (*P*0). **(Do not round intermediate calculations. Round your answer to 2 decimal places.)**

Ecology Labs Inc. will pay a dividend of $2.90 per share in the next 12 months (*D*1). The required rate of return (*Ke*) is 15 percent and the constant growth rate is 6 percent. **(Each question is independent of the others.)**

**a. **Compute the price of Ecology Labs’ common stock. **(Do not round intermediate calculations. Round your answer to 2 decimal places.)**

**b. **Assume *Ke*, the required rate of return, goes up to 19 percent. What will be the new price? **(Do not round intermediate calculations. Round your answer to 2 decimal places.)**

**c. **Assume the growth rate (*g*) goes up to 9 percent. What will be the new price? *Ke* goes back to its original value of 15 percent. **(Do not round intermediate calculations. Round your answer to 2 decimal places.)**

**d. **Assume *D*1 is $3.50. What will be the new price? Assume *Ke *is at its original value of 15 percent and *g* goes back to its original value of 6 percent. **(Do not round intermediate calculations. Round your answer to 2 decimal places.)**

Justin Cement Company has had the following pattern of earnings per share over the last five years:

Year

Earnings

per Share

20X1

$

9.00

20X2

9.54

20X3

10.11

20X4

10.72

20X5

11.32

The earnings per share have grown at a constant rate (on a rounded basis) and will continue to do so in the future. Dividends represent 40 percent of earnings.

**a. **Project earnings and dividends for the next year (20X6). **(Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answers to 2 decimal places.)**

**b. **If the required rate of return (*Ke*) is 13 percent, what is the anticipated stock price (*P*0) at the beginning of 20X6? **(Round the growth rate to the nearest whole percent. Do not round any other intermediate calculations. Round your answer to 2 decimal places.)**

Speedy Delivery Systems can buy a piece of equipment that is anticipated to provide an 11 percent return and can be financed at 8 percent with debt. Later in the year, the firm turns down an opportunity to buy a new machine that would yield a 18 percent return but would cost 20 percent to finance through common equity. Assume debt and common equity each represent 50 percent of the firm’s capital structure.

**a. **Compute the weighted average cost of capital.

**b. **Which project(s) should be accepted?

multiple choice

- New machine. Correct
- Piece of equipment.

A brilliant young scientist is killed in a plane crash. It is anticipated that he could have earned $300,000 a year for the next 25 years. The attorney for the plaintiff’s estate argues that the lost income should be discounted back to the present at 5 percent. The lawyer for the defendant’s insurance company argues for a discount rate of 10 percent.

What is the difference between the present value of the settlement at 5 percent and 10 percent? Compute each one separately. Use Appendix D for an approximate answer but calculate your final answer using the formula and financial calculator methods. **(Do not round intermediate calculations. Round your answers to 2 decimal places.)**

The Goodsmith Charitable Foundation, which is tax-exempt, issued debt last year at 7 percent to help finance a new playground facility in Los Angeles. This year the cost of debt is 15 percent higher; that is, firms that paid 9 percent for debt last year will be paying 10.35 percent this year.

**a. **If the Goodsmith Charitable Foundation borrowed money this year, what would the aftertax cost of debt be, based on their cost last year and the 15 percent increase?

**b. **If the receipts of the foundation were found to be taxable by the IRS (at a rate of 25 percent because of involvement in political activities), what would the aftertax cost of debt be?

Airborne Airlines Inc. has a $1,000 par value bond outstanding with 15 years to maturity. The bond carries an annual interest payment of $94 and is currently selling for $940. Airborne is in a 35 percent tax bracket. The firm wishes to know what the aftertax cost of a new bond issue is likely to be. The yield to maturity on the new issue will be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

**a. **Compute the yield to maturity on the old issue and use this as the yield for the new issue.

**b. **Make the appropriate tax adjustment to determine the aftertax cost of debt.

Terrier Company is in a 45 percent tax bracket and has a bond outstanding that yields 11 percent to maturity.

**a. **What is Terrier’s aftertax cost of debt?

**b. **Assume that the yield on the bond goes down by 1 percentage point, and due to tax reform, the corporate tax rate falls to 30 percent. What is Terrier’s new aftertax cost of debt?

**c. **Has the aftertax cost of debt gone up or down from part *a* to part *b*?

multiple choice

- It has gone up Correct
- It has gone down

Keyspan corp. is planning to issue debt that will mature in 2033. In many respects, the issue is similar to the currently outstanding debt of the corporation. Use Table 11-3.

**a. **Calculate the yield to maturity on similarly outstanding debt for the firm in terms of maturity. **(Input your answer as a percent rounded to 2 decimal places.)**

Assume that because the new debt will be issued at par, the required yield to maturity will be 0.25 percent higher than the value determined in part *a*.

**b. **What is the new yield to maturity?

**c. **If the firm is in a 25 percent tax bracket, what is the aftertax cost of debt for the yield determined in part *b?*

Wallace Container Company issued $100 par value preferred stock 10 years ago. The stock provided a 10 percent yield at the time of issue. The preferred stock is now selling for $69.

What is the current yield or cost of the preferred stock? (Disregard flotation costs.)

The treasurer of Riley Coal Co. is asked to compute the cost of fixed income securities for her corporation. Even before making the calculations, she assumes the aftertax cost of debt is at least 1 percent less than that for preferred stock.

Debt can be issued at a yield of 8.6 percent, and the corporate tax rate is 30 percent. Preferred stock will be priced at $54 and pay a dividend of $3.80. The flotation cost on the preferred stock is $2.

**a. **Compute the aftertax cost of debt.

**b. **Compute the aftertax cost of preferred stock.

**c. **Based on the facts given above, is the treasurer correct?

multiple choice

- No, the treasurer is incorrect.
- Yes, the treasurer is correct. Correct

Compute *Ke* and *Kn* under the following circumstances:

**a. ***D*1 = $9.00, *P*0 = $86, *g* = 6%, *F* = $4.00. **(Do not round intermediate calculations. Round your answers to 2 decimal places.)**

**b. ***D*1 = $0.34, *P*0 = $46, *g* = 8%, *F* = $4.50. **(Do not round intermediate calculations. Round your answers to 2 decimal places.)**

**c. ***E*1 (earnings at the end of period one) = $15, payout ratio equals 25 percent, *P*0 = $50, *g* = 5.5%, *F* = $2.80. **(Do not round intermediate calculations. Round your answers to 2 decimal places.)**

**d. ***D*0 (dividend at the beginning of the first period) = $4, growth rate for dividends and earnings (*g*) = 5%, *P*0 = $76, *F* = $1. **(Do not round intermediate calculations. Round your answers to 2 decimal places.)**

The aftertax cost of debt is 7.50 percent; the cost of preferred stock is 11.00 percent; and the cost of common equity (in the form of retained earnings) is 14.50 percent.

Calculate the Global Technology’s weighted cost of each source of capital and the weighted average cost of capital. **(Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)**

Notice that this problem asks for the weighted costs. These are the unweighted costs times the weights. Like this: (kd)(wd) = weighted cost of debt.

rev: 03_27_2021_QC_CS-259128

Sauer Milk Inc. wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans:

Cost

(aftertax)

Weights

**Plan A**

Debt

5.0

%

20

%

Preferred stock

10.0

10

Common equity

14.0

70

**Plan B**

Debt

5.2

%

30

%

Preferred stock

10.2

10

Common equity

15.0

60

**Plan C**

Debt

6.0

%

40

%

Preferred stock

15.7

10

Common equity

11.6

50

**Plan D**

Debt

12.0

%

50

%

Preferred stock

16.6

10

Common equity

13.6

40

**a-1. **Compute the weighted average cost for four plans. **(Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)**

**a-2. **Which of the four plans has the lowest weighted average cost of capital?

multiple choice

- Plan A
- Plan B
- Plan C Correct
- Plan D

A-Rod Manufacturing Company is trying to calculate its cost of capital for use in making a capital budgeting decision. Mr. Jeter, the vice-president of finance, has given you the following information and has asked you to compute the weighted average cost of capital.

The company currently has outstanding a bond with a 9.9 percent coupon rate and another bond with an 7.5 percent rate. The firm has been informed by its investment banker that bonds of equal risk and credit rating are now selling to yield 10.8 percent. The common stock has a price of $53 and an expected dividend (*D*1) of $1.73 per share. The historical growth pattern (*g*) for dividends is as follows:

$

1.28

1.42

1.57

1.73

The preferred stock is selling at $73 per share and pays a dividend of $6.90 per share. The corporate tax rate is 30 percent. The flotation cost is 2.0 percent of the selling price for preferred stock. The optimum capital structure for the firm is 30 percent debt, 10 percent preferred stock, and 60 percent common equity in the form of retained earnings.

**a. **Compute the average historical growth rate. **(Do not round intermediate calculations. Round your answer to the nearest whole percent and use this value as ****g****. Input your answer as a whole percent.)**

**b. **Compute the cost of capital for the individual components in the capital structure. **(Use the rounded whole percent computed in part a for ****g****. Do not round any other intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)**

**c. **Calculate the weighted cost of each source of capital and the weighted average cost of capital. **(Do not round intermediate calculations. Input your answers as a percent rounded to 2 decimal places.)**

Northwest Utility Company faces increasing needs for capital. Fortunately, it has an Aa3 credit rating. The corporate tax rate is 40 percent. Northwest’s treasurer is trying to determine the corporation’s current weighted average cost of capital in order to assess the profitability of capital budgeting projects.

Historically, the corporation’s earnings and dividends per share have increased about 7.2 percent annually and this should continue in the future. Northwest’s common stock is selling at $62 per share, and the company will pay a $2.50 per share dividend (*D*1).

The company’s $92 preferred stock has been yielding 5 percent in the current market. Flotation costs for the company have been estimated by its investment banker to be $4.00 for preferred stock.

The company’s optimum capital structure is 30 percent debt, 20 percent preferred stock, and 50 percent common equity in the form of retained earnings. Refer to the following table on bond issues for comparative yields on bonds of equal risk to Northwest.

Data on Bond Issues

Issue

Moody’s

Rating

Price

Yield to Maturity

Utilities:

Southwest electric power––7 1/4 2023

Aa2

$

885.18

8.54

%

Pacific bell––7 3/8 2025

Aa3

889.25

8.53

Pennsylvania power & light––8 1/2 2022

A2

960.66

8.55

Industrials:

Johnson & Johnson––6 3/4 2023

Aaa

860.24

8.34

%

Dillard’s Department Stores––7 1/8 2023

A2

940.92

8.66

Marriott Corp.––10 2015

B2

1,025.10

9.75

**a. **Compute the cost of debt, *Kd*. (Use the accompanying table—relate to the utility bond credit rating for yield.)

**b. **Compute the cost of preferred stock, *Kp*.

**c. **Compute the cost of common equity in the form of retained earnings, *Ke*.

**d. **Calculate the weighted cost of each source of capital and the weighted average cost of capital.

size=5 width=”100%” noshade style=”color:#CDD4E0″ align=left>

Delta Corporation has the following capital structure:

Cost

(aftertax)

Weights

Weighted

Cost

Debt (*Kd*)

5.2

%

10

%

0.52

%

Preferred stock (*Kp*)

12.2

20

2.44

Common equity (*Ke*) (retained earnings)

7.1

70

4.97

Weighted average cost of capital (*Ka*)

7.93

%

**a. **If the firm has $28 million in retained earnings, at what size capital structure will the firm run out of retained earnings? **(Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)**

**b. **The 5.2 percent cost of debt referred to earlier applies only to the first $15 million of debt. After that the cost of debt will go up. At what size capital structure will there be a change in the cost of debt? **(Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)**

The Nolan Corporation finds it is necessary to determine its marginal cost of capital. Nolan’s current capital structure calls for 30 percent debt, 20 percent preferred stock, and 50 percent common equity. Initially, common equity will be in the form of retained earnings (*Ke*) and then new common stock (*Kn*). The costs of the various sources of financing are as follows: debt (after-tax), 7.6 percent; preferred stock, 7 percent; retained earnings, 13 percent; and new common stock, 14.2 percent.

**a. **What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, *Ke*.)

**b. **If the firm has $14 million in retained earnings, at what size capital structure will the firm run out of retained earnings? **(Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)**

**c. **What will the marginal cost of capital be immediately after that point? (Equity will remain at 50 percent of the capital structure, but will all be in the form of new common stock, *Kn*.)

**d. **The 7.6 percent cost of debt referred to earlier applies only to the first $21 million of debt. After that, the cost of debt will be 9.2 percent. At what size capital structure will there be a change in the cost of debt? **(Enter your answer in millions of dollars (e.g., $10 million should be entered as “10”).)**

**e. **What will the marginal cost of capital be immediately after that point? (Consider the facts in both parts *c* and *d*.)

Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume:

*Rf*

=

6

%

*Km*

=

9

%

β

=

1.5

*D*1

=

$

0.80

*P*0

=

$

18

*g*

=

6

%

**a. **Compute *Ki* (required rate of return on common equity based on the capital asset pricing model).

**b. **Compute *Ke* (required rate of return on common equity based on the dividend valuation model).