Cost of Capital

Problem 1:

Calculate the after-tax cost of debt under the following conditions if the maturity value of the debt is $1,000, interest is paid annually, and the corporate tax rate is 35 percent.

a. Coupon interest rate is 8 percent, proceeds are $900, and the life is 20 years.

b. Bond pays $100 per year in interest, proceeds are $960, and life is 10 years.

c. Coupon interest rate is 14 percent, proceeds are $1,120, and bond has 30-year life.

d. Proceeds are $1,000, coupon interest rate is 12 percent, and the life is 5 years.

Problem 2:

What is the after-tax cost of preferred stock under the following circumstances?

a. Par is $80, dividend is $8 per year, and the proceeds are $76.

b. Proceeds are $46, and dividends are $7.

c. Par is $60, dividend is 9 percent (of par), and proceeds are $55.

d. Par is $40, dividend is 11 percent (of par), and proceeds are $40.

Problem 3:

Luxury Suites has hired you as a consultant to estimate its cost of common equity. After talking with its CFO and an econometric forecasting firm, you have come up with the following facts and estimates:

Estimates Year Dividends per Share

P0 = $85 -5 $1.21

bLuxury Suites = 1.50 -4 1.21

Treasury security rate = 10% -3 1.30

Market yield on comparable -2 1.40

quality long-term debt = 13% -1 1.71

Expected return on the market 0 1.86

portfolio = 16%

Expected risk premium of stocks

over bonds = 4%

Current earnings per share, EPS = $5.75

Luxury Suites plans to use 30 percent debt and 70 percent equity for its incremental financing. Also, the firm’s marginal tax rate is 33 percent.

a. What do you estimate the past growth rate in cash dividends per share has been? Employ this as your estimate of g (round to the nearest whole number).

b. What is the estimated cost of common equity employing the following approaches: (1) dividend valuation, (2) CAPM, and (3) bond yield plus expected risk premium?

c. Explain why one of the estimates from (b) is substantially lower than the other two.

d. Take an average of all three answers from (b) for your estimate of Luxury’s cost of common equity.

d. What is your estimate of Luxury’s opportunity cost of capital? How confident of it are you?