The Holmes Company’s currently outstanding bonds have an 8% coupon and a 10% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40%, what is Holmes’ after-tax cost of debt?

Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average-, high-, and low-risk projects?

Midwest Water Works estimates that its WACC is 10.5%. The company is considering the following capital budgeting projects: $$ \begin{matrix} \text{Project } & \text{Size} & \text{Rate of Return}\\ \text{A} & \text{\$ 1 million} & \text{12.0\\%}\\ \text{B} & \text{2 million} & \text{11.5}\\ \text{C} & \text{2 million} & \text{11.2}\\ \text{D} & \text{2 million} & \text{11.0}\\ \text{E} & \text{1 million} & \text{10.7}\\ \text{F} & \text{1 million} & \text{10.3}\\ \text{G} & \text{1 million} & \text{10.2}\\ \end{matrix} $$ Assume that each of these projects is just as risky as the firm’s existing assets and that the firm may accept all the projects or only some of them. Which set of projects should be accepted? Explain.

Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 40%. The current stock price is $\mathrm{P}_{0}=\$ 22.00$. The last dividend was $\mathrm{D}_{0}=\$ 2.25$, and it is expected to grow at a 5% constant rate. What is its cost of common equity and its WACC?

Olsen Outfitters Inc. believes that its optimal capital structure consists of $55\%$ common equity and $45\%$ debt, and its tax rate is $40\%$. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $\$4$ million of retained earnings with a cost of $\mathrm{r}_{\mathrm{s}}=11 \%$. New common stock in an amount up to $\$8$ million would have a cost of $\mathrm{r}_{\mathrm{e}}=12.5 \%$. Furthermore, Olsen can raise up to $\$4$ million of debt at an interest rate of $\mathrm{r}_{\mathrm{d}}=9 \%$ and an additional $\$5$ million of debt at $r_{d}=13 \%$. The CFO estimates that a proposed expansion would require an investment of $\$8.2$ million. What is the WACC for the last dollar raised to complete the expansion?

The Paulson Company’s year-end balance sheet is shown below. Its cost of common equity is 14%, its before-tax cost of debt is 10%, and its marginal tax rate is 40%. Assume that the firm’s long-term debt sells at par value. The firm’s total debt, which is the sum of the company’s short-term debt and long-term debt, equals $1,167. The firm has 576 shares of common stock outstanding that sell for$4.00 per share. Calculate Paulson’s WACC using market-value weights.

$$\begin{matrix} \text{Assets} & \text{ } & \text{Liabilities and Equity}\\ \text{Cash} & \text{\$ 120} & \text{Accounts payable and accruals} & \text{\$ 10}\\ \text{Accounts receivable} & \text{240} & \text{Short-term debt} & \text{47}\\ \text{Inventories} & \text{360} & \text{Long-term debt} & \text{1.120}\\ \text{Plant and equipment, net} & \text{2.160} & \text{Common equity} & \text{1.703}\\ \text{Total assets} & \text{\$ 2.880} & \text{Total liabilities and equity} & \text{\$ 2.880}\\ \end{matrix}$$

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of $r_{d}=9 \%$ structure, which calls for 35% debt and 65% common equity. Its last dividend $\left(D_{0}\right)$ was $2.20, its expected constant growth rate is 6%, and its common stock sells for$26. EEC’s tax rate is 40%. Two projects are available: Project A has a rate of return of 12%, and Project B’s return is 11%. These two projects are equally risky and about as risky as the firm’s existing assets. a. What is its cost of common equity? b. What is the WACC? c. Which projects should Empire accept?

The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year came solely in the form of retained earnings versus some equity from the sale of new common stock? Would the calculated WACC depend in any way on the size of the capital budget? How might dividend policy affect the WACC?

Javits & Sons's common stock currently trades at $\$ 30.00$ a share. It is expected to pay an annual dividend of $\$ 3.00$ a share at the end of the year $\left(D_1=\$ 3.00\right)$, and the constant growth rate is $5 \%$ a year.

a. What is the company's cost of common equity if all of its equity comes from retained earnings?

b. If the company issued new stock, it would incur a $10 \%$ flotation cost. What would be the cost of equity from new stock?

The Bouchard Company’s EPS was $6.50 in 2016, up from$4.42 in 2011. The company pays out 40% of its earnings as dividends, and its common stock sells for $36.00. a. Calculate the past growth rate in earnings. (Hint: This is a 5-year growth period.) b. The last dividend was$$\mathrm{D}$_{0}=0.4($6.50)=$ 2.60$. Calculate the next expected dividend, $D_1$, assuming that the past growth rate continues. c. What is Bouchard's cost of retained earnings, $r_s$?

Answer the following.

Pearson Motors has a target capital structure of 30 percent debt and 70 percent common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is 9 percent, and its tax rate is 40 percent. Pearson's CFO estimates that the company's WACC is 10.50 percent. What is Pearson's cost of common equity?

Percy Motors has a target capital structure of $40 \%$ debt and $60 \%$ common equity, with no preferred stock. The yield to maturity on the company's outstanding bonds is $9 \%$, and its tax rate is $40 \%$. Percy's CFO estimates that the company's WACC is $9.96 \%$. What is Percy's cost of common equity?

Tunney Industries can issue perpetual preferred stock at a price of $\$ 47.50$ a share. The stock would pay a constant annual dividend of $\$ 3.80$ a share. What is the company's cost of preferred stock, $\mathrm{r}_{\mathrm{p}}$ ?

A company’s fixed operating costs are $430,000, its variable costs are$2.95 per unit, and the product’s sales price is $4.50. What is the company’s break-even point; that is, at what unit sales volume will its income equal its costs?