Cost of Capital Homework Problems
Q1.1. As a financial analyst for National Engineering, you are required to estimate the cost of capital the firm should use in evaluating its heavy construction projects. The firm’s balance sheet data and other information are listed below. Assume a 35% corporate tax rate.
a. What is your estimate? What assumptions must you make to calculate this estimate?
b. What qualifications to this estimate should you mention in your report when National applies this rate to its various projects?
Selected Balance Sheet Items
Bonds (see market data)
Preferred stock $400,000
Common Stock $800,000
Retained Earnings $2,000,000
Market Value Yield
8%, 10-year $250,000 12%
12%, 15-year $1,000,000 15%
21%, 1-year $250,000 11%
Average dividend growth (5 years) = 10%
Current Dividend Yield = 7%
Price = $47.25
Shares = 100,000
$4.50 preferred dividend
Price = $22.50
Shares = 20,000
Q 1.2. Given the following information for Columbia Power Co., find the WACC. Assume the company’s tax rate is 35%.
Debt: 3000 8% coupon bonds outstanding, $1000 par value, ten years to maturity, selling for 101% of par; the bonds make semiannual interest payments
Common Stock: 50,000 shares outstanding selling for $62 per share; the beta is 1.10
Preferred Stock: 10,000 shares of 4% preferred stock outstanding, $100 par value, currently selling for $60 per share
Market: 5% market risk premium and 6% risk-free rate
Q1.3. Independence Mining Corporation has 7 million shares of common stock outstanding, 1million shares of 6% preferred stock outstanding, and 100,000 9% semiannual bonds outstanding, par value $1000 each. The common stock currently sells for $35 per share and has a beta of 1.0, the preferred stock currently sells for $60 per share, and the bonds have 15 years to maturity and sell for 89% of par. The market risk premium is 8%, T-bills are yielding 7%, and Independence Mining’s tax rate is 34%.
a. What is the firm’s market value capital structure?
b. If Independence Mining is evaluating a new investment project that has the same risk as the firm’s typical project, what rate should the firm use to discount the project’s cash flows?