Financial Management Tutorial Questions (Not Mine)

Class for Lectures 8

Cost of Capital and Capital Structure

Question 1

GBK Inc. has 40% debt and 60% equity in its capital structure. Cost of debt (before tax) is 11%. Currently, GBK stock is selling at a price of $40 and is about to pay a dividend of $3. Dividends are expected to grow at a constant rate of 8%. Calculate the cost of equity and the tax-adjusted weighted average cost of capital (WACC). Assume a tax rate of 36%.

Question 2

BP has 4.6 million shares outstanding, now trading at $32 per share, and its total debt value is $18 million. The company pays tax at a marginal rate of 28%. Moreover, it has issued long-term bonds at an interest rate of 6%. Finally, BP has an asset beta of 1.2 while the risk-free interest rate is 4% and the return on the market is 8%. What is BP’s after-tax weighted average cost of capital (WACC)?

Question 3

Gaucho Services starts life with all-equity financing and a cost of equity of 14%. Suppose it refinances to the following market-value capital structure:

Debt (D) 45% at Rd=9.5%

Equity E 55%

Use MM’s proposition 2 to calculate the new cost of equity. Gaucho pays taxes at a marginal rate of Tc=40%. Calculate Gaucho’s after-tax weighted-average cost of capital.

Question 4

Omega Corporation has 10 million shares outstanding, now trading at $55 per share. The firm has estimated the expected rate of return to shareholders at about 12%. It has also issued $200-million long-term bonds at an interest rate of 7%. It pays tax at a marginal rate of 35%.

a. What is Omega’s after-tax WACC?

b. How much higher would WACC be if Omega used no debt at all? (assume that the firm’s overall beta is not affected by its capital structure or the taxes saved because debt interest is tax-deductible)