Practice Questions Week 11

Q1. Flotation costs and the cost of debt

In March of 2020 PepsiCo, Inc. (PEP) sold $750 million worth of 40-year 3.875% coupon bonds
that pay semi-annual interest. At the time the bonds were issued, the market paid $994.20 per bond
and the flotation cost was $18.76 per bond. Pepsi’s corporate tax rate is 21%.

a) Ignoring flotation costs, what is Pepsi’s before-tax and after-tax costs of debt?
b) Considering flotation costs, what is Pepsi’s before-tax and after-tax costs of debt?

Solution:
a
Using a calculator, solve for I/Y which will give you the before-tax cost of debt:
P/Y = 2 (semiannual interest payments)
N = 40*2 = 80 (semiannual interest payments)
PV = -$994.20
PMT = $1,000*(3.875% / 2) = $19.375
FV = $1,000
I/Y = 3.90%
Using spreadsheet to solve for RATE:
=rate(80,19.375,-994.20,1000) = 1.952%
To get the annual rate, multiply the answer by 2 = 1.952% × 2 = 3.90%
After-tax cost of debt = 3.90% (1 – 0.21) = 3.08%

b.
Flotation costs per bond = $18.76
Selling price per bond = $994.20 – $18.76 = $975.44
Using a calculator, solve for I/Y which will give you the before-tax cost of debt:
P/Y = 2 (semiannual interest payments)
N = 40*2 = 80 (semiannual interest payments)
PV = -$975.44
PMT = $1,000*(3.875% / 2) = $19.375
FV = $1,000
I/Y = 4.00%
Using spreadsheet to solve for RATE:
=rate(80,19.375,-975.44,1000) = 2.00%
To get the annual rate, multiply the answer by 2 = 2.00% × 2 = 4.00%
After-tax cost of debt = 4.00% (1 – 0.21) = 3.16%

Q2. Before-tax cost of debt and after-tax cost of debt

Jim Paige is opening his own restaurant, and he is taking out a 10-year mortgage. Jim will borrow
$400,000 from a bank and to repay the loan, he will make 120 monthly payments (principal and
interest) of $4,420.82 per month over the next 10 years. Jim is in the 30% tax bracket.

a) What is the before-tax interest rate (per year) on Jim’s loan?

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 b) What is the after-tax interest rate that Jim is paying?

Solution:
a. PV = 400,000, PMT = –4420.82, N = 10 × 12 = 120, FV = 0
Solving for I = 0.4917% per month
So, APR will be = (1 + 0.004917)12 – 1 = 0.06063 or 6.063%
b. The after-tax cost of debt is given by rd × (1 – T), where T is the tax rate. So, with a tax
rate of 30%, the after-tax interest rate will be 6.063% × (1 – 0.3) = 4.243%

Q3. Cost of preferred stock

Mavis Taylor Corporation has just issued preferred stock. The stock has a 6% annual dividend and
a $100 par value, and was sold at $98.5 per share. Flotation costs were an additional $3 per share.

a) Calculate the cost of the preferred stock.

b) If the firm sells the preferred stock with a 10% annual dividend and net $93.00 after
flotation costs, what is its cost?

Solution:
The cost of preferred stock is given by rp = Dp  Np, where Dp is the annual preferred
dividends (in dollars) and Np is the net proceeds from issuing preferred stock.
a. Np = Sales price – Flotation costs = $98.50 – $3.00 = $95.50. Given an 6% annual
dividend ($6),
rp = $6  $95.50 = 0.062827 = 6.28%
b. Np is now given as $93. Given an 10% annual dividend ($10), rp = $10  $93 = 0.1075 =
10.75

Q4. Cost of common stock equity: CAPM

Brigham Jewellery Corporation common stock has a beta, β of 1.8. The risk-free rate is 5%, and
the market return is 16%.
a) Determine the risk premium on Brigham common stock.
b) Determine the required return that Brigham common stock should provide.
c) Determine Brigham’s cost of common stock equity using the CAPM
Solution:
According to CAPM, the required return on asset j is given by RF + [j  (rm − RF)], where j
is the beta for asset j, RF is the risk-free rate, and rm is the expected return on the market
portfolio.

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 rs = RF + [b × (rm − RF)]
rs = 5% + 1.8 × (16% − 5%)
rs = 5% + 19.8%
rs = 24.8%
a. Risk premium = 19.8%
b. Rate of return = 24.8%
c. Cost of common equity using the CAPM = 24.8%

Q5. Cost of common stock equity

Charles Fabrics wishes to measure its cost of common stock equity. The firm’s stock is currently
selling for €64.50. The firm just recently paid a dividend of €4. The firm has been increasing
dividends regularly. Five years ago, the dividend was just €2.50.
After underpricing and flotation costs, the firm expects to net €62 per share on a new issue.
a) Determine average annual dividend growth rate over the past five years. Report your
answer to the nearest whole percentage. Using that growth rate, what dividend would you
expect the company to pay next year?
b) Determine the net proceeds, 𝑁𝑛 , that the firm will receive.
c) Using the constant-growth valuation model, determine the required return on the
company’s stock, 𝑟𝑠 , which should equal the cost of retained earnings, 𝑟𝑟 .
d) Using constant-growth valuation model, determine the cost of new common stock, 𝑟𝑛 .
Solution:
a. Assuming the rate of growth to be r, we can say:
€2.5 × (1 + r)5 = €4
Or, (1 + r)5 = 4/2.5
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Or, 1 + r = √(4 ÷ 2.5) = 1.09856 or r = 0.09856 or 9.856%
So, the expected dividend for the next year should be:
€4 × (1 + 0.09856) = €4.394
b. Net proceeds are given as €62 per share
c. The required return on Charles Fabrics can be found with the Gordon model:
𝐷1
𝑟𝑠 = +g
𝑃0
where:
D1 = Next annual dividend payment in dollars
P0 = Current price of common stock
g = Dividend growth rate

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 The dividend growth rate was determined to be 9.856% in part (a), the next dividend
should be €4.394, and the current price of the stock is given as €64.50, so the required
return is
(€4.394  € 64.50) + 0.09856 = 0.16668 or 16.68%.
d.The cost of new common stock for Charles (rn) can be found with:
𝐷1
𝑟𝑛 = +g
𝑁𝑛
where:
D1 = Next annual dividend payment in euros
Nn = Net proceeds from issue of common stock
g = Dividend growth rate
As the net proceeds are given to be €62, so rn − (€4.394  €62) +0.09856 = 0.1694 or
16.94%
Q6. The effect of tax rate on WACC
Rayyan Games, an IT firm, wishes to explore the effect on its cost of capital of the rate at which
the company pays taxes. The firm wishes to maintain a capital structure of 40% debt, 30%
preferred stock, and 30% common stock. The cost of financing with retained earnings is 12%, the
cost of preferred stock financing is 8%, and the before-tax cost of debt financing is 6%. Calculate
the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c.
a) Tax rate = 40%
b) Tax rate = 35%
c) Tax rate = 15%
d) Describe the relationship between changes in the rate of taxation and the WACC. Do you
think higher or lower tax rates make debt financing more attractive? Why?
Solution:
Weighted average cost of capital: rwacc = [wd  ((1 − T)  rd)] + (wp  rp) + (ws  rs), where wd is the
weight of debt in the firm’s capital structure, T is the firm’s tax rate, rd is the before-tax cost of debt,
wp the weight on preferred stock, rp the cost of preferred stock, ws the weight on common stock, and rs
the cost of common stock. Given wd = 40%, rd = 6%, wp = 30%, rp = 8%, ws = 30%, and rs = 12%:
a. And a tax rate of 40%, rwacc = (0.40)(0.06)(1 – 0.40) + (0.30)(0.08) + (0.30)(0.12) =
0.0744
= 7.44%.
b. And a tax rate of 35%, rwacc = (0.40)(0.06)(1 – 0.35) + (0.30)(0.08) + (0.30)(0.12) =
0.0756
= 7.56%.
c. And a tax rate of 15%, rwacc = (0.40)(0.06)(1 – 0.15) + (0.30)(0.08) + (0.30)(0.12) =
0.0804
= 8.04%.
d. The weighted-average cost of capital increases as the tax rate decreases. The
deductibility of interest expense is a form of government subsidy. Lower tax rates mean
smaller subsidies as well as a higher cost of debt and long-term capital overall.

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Q7. Calculation of individual costs and WACC
Carnival Corporation (CCL) recently sold new bonds at a discount price of $990. The bonds have
a short three-year maturity, have an 11.5% coupon rate, and pay interest semi-annually. In addition
to the $10.913 billion worth of bonds outstanding, Carnival also has $11.014 billion worth of
common stock equity outstanding. Carnival’s stock has a beta of 1.96. Currently the expected
return on the market portfolio and the risk-free rate are 6.8% and 0.38%, respectively.
a) Calculate the market value weights for Carnival’s capital structure.
b) Calculate Carnival’s cost of equity using the CAPM.
c) Calculate Carnival’s before-tax cost of debt.
d) Calculate Carnival’s current WACC using a 21% corporate tax rate.
Solution:

Weight in common stock equity = $11,014,000,000/$21,927,000,000 = 0.5023

Weight in debt = $10,913,000,000/$21,927,000,000 = 0.4977
b. CAPM cost of equity = 0.38% + 1.96 (6.8%-0.38%) = 12.96%
c.
Par value $1,000
Coupon rate 11.50%
Semi-annual coupon payment $57.50
Years to maturity 3.0
Bond value $990.00
Annual cost of debt 11.91%
Annual cost of debt is calculated as follows:
Using a calculator, solve for I/Y which will give you the before-tax cost of debt:
P/Y = 2 (semiannual interest payments)
N = 3*2 = 6 (semiannual interest payments)
PV = -$990.00
PMT = $1,000*(11.50% / 2) = $57.50
FV = $1,000
I/Y = 11.91%
Alternatively, using a spreadsheet to solve for RATE, the before-tax cost of debt is:
=rate(6,57.50,-990.00,1000) = 5.953%
To get the annual rate, multiply the answer by 2 = 5.953% × 2 = 11.91%

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d.
Weight in retained earnings 0.5023 part a
Cost of common stock equity 12.96% part b
Weight in debt 0.4977 part a
Tax rate 21% given
After-tax cost of debt 9.41%
WACC using retained earnings 11.19%

Where after-tax cost of debt = 11.91% (from part c) * (1-0.21) = 9.41%

And WACC using retained earnings = 0.5023*12.96% + 0.4977*9.41% = 11.19%