COST OF CAPITAL

CFA LEVEL - 1 COST OF CAPITAL

a. Calculate and interpret the weighted average cost of capital (WACC) of a
company
b. Describe how taxes affect the cost of capital from different capital sources

QUESTIONS 1

A firm’s before-tax costs of debt, preferred stock, and equity are 12%, 17%, and 20%,
respectively. Assuming equal funding from each source and a marginal tax rate of 40%,
the weighted average cost of capital (%) is closest to:
A. 14.7%.
B. 9.8%.
C. 13.9%.

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Solution

A is correct

WACC = Wd ×rd(1−t)+wp × rp+we × re

= (1/3)(0.12)(1−0.4)+(1/3)(0.17)+(1/3)(0.20)
= 14.73%

B is incorrect because if all costs are considered after tax:

[(1/3)(0.12) + (1/3)(0.17) + (1/3)(0.20)] × (1 − 0.4) = 9.8%

C is incorrect because if tax effect on cost of debt is miscalculated:

(1/3)(0.12)(0.4) + (1/3)(0.17) + (1/3)(0.20) = 13.93%

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b. Describe how taxes affect the cost of capital from different capital sources

QUESTIONS 2

A firm with a marginal tax rate of 40% has a weighted average cost of capital of 7.11%.
The before-tax cost of debt is 6%, and the cost of equity is 9%. The weight of equity in
the firm’s capital structure is closest to:
A. 79%
B. 65%
C. 37%

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Solution

B is correct.
WACCWACC = Wd × rd(1−t)+we × re, where wd+we= 1
7.11 = (1−we)×6×(1−0.4)+we×9
we = 65%

A is incorrect because it is calculated by dividing 7.11 by 9.

C is incorrect because it fails to adjust debt for taxes.

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b. Describe how taxes affect the cost of capital from different capital sources

QUESTIONS 3

The cost of which source of capital most likely requires adjustment for taxes in the
calculation of a firm’s weighted average cost of capital?
A. Common stock
B. Preferred stock
C. Bonds

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Solution

C is correct. Bonds are a form of debt that must be adjusted for taxes when calculating
the weighted average cost of capital.

A is incorrect because adjustment for taxes is applicable for the cost of debt and not in
the cost of equity.

B is incorrect because adjustment for taxes is applicable for the cost of debt and not in
the cost of equity.

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b. Describe how taxes affect the cost of capital from different capital sources.

QUESTIONS 4

Which of the following statements is most likely true?

A. The investment opportunity schedule, for a given company, is upward sloping
because as a company invests more in capital projects, the returns from investing
keep on increasing.
B. In order to determine the after-tax cost of debt, the appropriate tax rate to use is
the average rate.
C. The after-tax debt cost, for a given company, is generally less than both the cost of
preferred equity and the cost of common equity.

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Solutions

C is correct. Generally, debt is less costly than both preferred and common stock. If
interest expense is tax deductible, then the cost of debt is further reduced.

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c. Describe the use of target capital structure in estimating WACC and how target
capital structure weights may be determined.

QUESTIONS 5

In collecting information to conduct financial analysis on Budweiser’s new product line

of sparkling water, Simon Hayes found that Budweiser currently has a debt-to-equity
ratio of 0.55 and the new product line would be financed with $45 million of debt and
$65 million of equity. Hayes has estimated the equity beta and asset beta of comparable
companies to determine the valuation impact of the new product line on Budweiser’s
value. Which of the following statements for calculating the equity beta for this new
line of product is most accurate?
A. Using the new debt-to-equity ratio of Budweiser that would result from the
additional $45 million debt and $65 million equity is appropriate.
B. Using the current debt-to-equity ratio of 0.55 is appropriate.
C. Using the current debt-to-equity ratio of 0.55 is not appropriate, but the debt-to-
equity ratio of the new product line i.e. 0.69 is appropriate.

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Solutions

C is correct. When making adjustments from the asset beta, derived from the
comparables, to calculate the equity beta of the new product, the correct approach is to
use the debt-to-equity ratio of the new product line.

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d. Explain how the marginal cost of capital and the investment opportunity schedule
are used to determine the optimal capital budget.

QUESTIONS 6

Analyst 1: A company’s optimal capital budget occurs at the intersection of the net
present value and the internal rate of return profiles.

Analyst 2: A company’s optimal capital budget occurs at the intersection of the

marginal cost of capital and the investment opportunity schedule.
Which analyst’s statements is most likely correct?
A. Analyst 1.
B. Analyst 2.
C. Neither.

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Solutions

B is correct. The point at which the marginal cost of capital intersects the investment
opportunity schedule is the optimal capital budget.

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e. Explain the marginal cost of capital’s role in determining the net present value of
a project

QUESTIONS 7

When estimating the NPV for a project with a risk level higher than the company’s
average risk level, an analyst will most likely discount the project’s cash flows by a rate
that is:
A. determined by the firm’s target capital structure.
B. below the WACC.
C. above the WACC.

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Solution

C is correct. If the systematic risk of the project is above average relative to the
company’s current portfolio of projects, an upward adjustment is made to the
company’s MCC or WACC.

A is incorrect because the firm’s target capital structure is used to determine WACC,
but in this case we need more adjustment in the company’s WACC.

B is incorrect because if the systematic risk of the project is above average relative to the
company’s current portfolio of projects, an upward adjustment is made to the
company’s MCC or WACC.

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e. Explain the marginal cost of capital’s role in determining the net present value of
a project.

QUESTIONS 8

Information about a company is provided below. It is expected that the company will
fund its capital budget without issuing any additional shares of common stock:
Source of capital Capital structure Marginal after-
proportion tax cost
Long-term debt 30% 12%
Preferred stock 5% 15%
Common equity 65% 20%

Net present values of three independent projects:

Storage project: $348
Upgrade project: $0
Production line improvement project: -$231

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If no significant size or timing differences exist among the projects and the projects all
have the same risk as the company, which project has an internal rate of return that
exceeds 17.35 percent?
A. All three projects.
B. Storage project only.
C. Storage project and upgrade project.

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Solution

B is correct.
The WACC of the company is calculated as follows:
0.3  12%  0.05  15%  0.65  20%  17.35% To have a positive NPV, a project must have
an IRR greater than the WACC used to calculate the NPV. Only the storage project has
a NPV greater than $0 (at the company’s WACC of 17.35%), therefore only the storage
project has an IRR that exceeds 17.35%.

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e. Explain the marginal cost of capital’s role in determining the net present value of a
project.

QUESTIONS 9

If we use the company’s marginal cost of capital in the calculation of the NPV of a
project, we are least likely assuming that:
A. the project has the same risk as the average-risk project of the company.
B. no new projects will be undertaken until the current project is completed.
C. the project will have a constant target capital structure throughout its useful life.

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Solutions

B is correct. Statement B is not an assumption we make when using the company’s

marginal cost of capital to calculate the NPV of a project.

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f. Calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach

QUESTIONS 10

A company recently issued a 10-year, 6% semi-annual coupon bond for $864. The bond
has a maturity value of $1,000. If the marginal tax rate is 35%, the after-tax cost of debt
(%) is closest to:
A. 3.9%
B. 5.2%
C. 2.6%

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Solution

B is correct. The pre-tax cost of debt is the yield to maturity (YTM) of the bond.
Using a financial calculator, enter N = 20 (semiannual periods), PV = −864, PMT = 30,
and FV = 1,000.
Compute I/Y. The six-month yield (or calculated I/Y) is 4%. The YTM is obtained by
doubling the six-month yield to get 8%. Multiplying the pre-tax cost of debt by (1 − Tax
rate) gives the result of 8 × (1 − 0.35) = 5.2%.
A is incorrect because if the after-tax amount of the coupon rate is used, the result will
be 0.06(1 − 0.35) = 3.9%.
C is incorrect because if the after-tax cost for six-month yield is used, the result will be
0.04(1 − 0.35) = 2.6%.

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f. Calculate and interpret the cost of debt capital using the yield-to-maturity approach
and the debt-rating approach

QUESTIONS 11

When computing the weighted average cost of capital (WACC) and assuming a fixed-
rate non-callable bond is currently selling above par value, the before-tax cost of debt
is closest to the:
A. coupon rate.
B. yield to maturity.
C. current yield.

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Solution

B is correct. With a fixed-rate non-callable bond, the before-tax cost of debt is the
bond’s yield to maturity.

A is incorrect because the coupon rate is higher than the yield-to-maturity based on the
bond selling above par value.

C is incorrect because the current yield is the coupon divided by the bond price which
does not equal the yield-to-maturity.

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f. Calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach.

QUESTIONS 12

Which of the following statements describe matrix pricing most accurately? Matrix
pricing:
A. is used to calculate the coupon rate of a bond.
B. helps to determine the equity risk premium in the market.
C. is used in pricing bonds through the debt-rating approach.

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Solutions

C is correct. Debt-rating approach which is used to estimate the before-tax cost of debt
is an example of the matrix pricing method. Matrix pricing method involves pricing on
the basis of valuation - relevant characteristics.

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g. Calculate and interpret the cost of noncallable, nonconvertible preferred stock

QUESTIONS 13

A company’s $100 par value preferred stock with a dividend rate of 9.5% per year is
currently priced at $103.26 per share. The company’s earnings are expected to grow at
an annual rate of 5% for the foreseeable future. The cost of the company’s preferred
stock is closest to:
A. 9.5%
B. 9.2%
C. 9.7%

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Solution

B is correct. rp = Dp/Pp (or Dividend/Price) = ($100 × 0.095)/$103.26 = 9.2%.

A is incorrect because it uses $100 as the denominator, i.e., ($100 × 0.095)/$100 = 9.5%.

C is incorrect because it assumes 5% growth in the dividend, i.e., 9.5 × (1.05)/103.26 =

9.7%.

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g. Calculate and interpret the cost of noncallable, nonconvertible preferred stock.

QUESTIONS 14

RBS Insurance Limited issued to retail investors a fixed-rate perpetual preferred stock
four years ago at par value of $10 per share with a $2.85 dividend. If the company had
issued the preferred stock today, the yield would be 8.5 percent. The current value of
the stock is:
A. $10.00.
B. $33.53.
C. $43.85.

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Solutions

B is correct. The company can issue preferred stock today at 8.5%.

$2.85
Pp   $33.53
0.085

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h. Calculate and interpret the cost of equity capital using the capital asset pricing
model approach, the dividend discount model approach, and the bond-yield-plus
risk-premium approach

QUESTIONS 15

A company’s asset beta is 1.2 based on a debt-to-equity ratio (D/E) of 50%. If the
company’s tax rate increases, the associated equity beta will most likely:
A. increase.
B. decrease.
C. remain unchanged.

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Solution

B is correct.
βequity = β asset × [1+(1−tax rate)×D/E]
If the tax rate increases, then the bracketed term (1 − tax rate) decreases, making the
equity beta decrease because the asset beta is unchanged.

A is incorrect because the equity beta decreases.

C is incorrect because the equity beta decreases.

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h. Calculate and interpret the cost of equity capital using the capital asset pricing
model approach, the dividend discount model approach, and the bond-yield-plus
risk-premium approach.

QUESTIONS 16

A company wants to determine the cost of equity to use in calculating its weighted
average cost of capital. The controller has gathered the following information:

Rate of return on 3-month Treasury bills: 2.0%

Rate of return on 10-year Treasury bonds: 2.4%
Market equity risk premium: 4.0%
The company’s estimated beta: 1.2
The company’s after-tax cost of debt: 7.0%
Risk premium of equity over debt: 3.0%
Corporate tax rate: 30%

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Using the capital asset pricing model (CAPM) approach, the cost of equity (%) for the
company is closest to:
A. 6.8
B. 7.2
C. 7.9

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Solutions

B is correct.
The cost of equity using CAPM:
Cost of equity = 2.4 + 1.2 × (4.0) = 7.2%.

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h. Calculate and interpret the cost of equity capital using the capital asset pricing
model approach, the dividend discount model approach, and the bond-yield-plus
risk-premium approach

i. Explain and demonstrate the correct treatment of flotation costs

QUESTIONS 17

A company intends to issue new common stock with floatation costs of 5.0% per share.
The expected dividend next year is $0.32, and the dividend growth rate is expected to
be 10% in perpetuity. Assuming the shares are issued at a price of $14.69, the cost (%) of
external equity for the firm is closest to:
A. 12.2
B. 12.5
C. 12.3

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Solution

C is correct. Use the following formula:

re = [D1/P0(1−f)]+g

0.1229 = [$0.32/$14.69(1−0.05)]+0.10

Where
D1 = Expected dividend
P0 = Current price
f = Flotation costs
g = Growth rate
A is incorrect because it does not include floatation costs. B is incorrect because it treats
D1 as the current dividend making it equal $0.32 × (1 + 0.10) in the equation.

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i. Calculate and interpret the beta and cost of capital for a project

QUESTIONS 18

A company has an equity beta of 1.4 and is 60% funded with debt. Assuming a tax rate
of 35%, the company’s asset beta is closest to:
A. 0.98
B. 1.01
C. 0.71

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Solution

C is correct.
Note: 60% debt financing is equivalent to a debt-to-equity ratio of 1.50 = 0.60/(1 − 0.60).

βAsset = βE×{1/[1+(1−t)D/E]}
= 1.4/[1+(1−0.35)×1.5]
= 0.70890

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i. Calculate and interpret the beta and cost of capital for a project.

QUESTIONS 19

Kyushu Motors has historically maintained a long-term stable debt-to-equity ratio of

0.60. To finance expansion plans in Africa, recent bank borrowing raised this ratio to
0.75. The most likely effect of this increased leverage on the asset beta and equity beta of
the company is that:
A. the asset beta will rise and the equity beta will also rise.
B. the asset beta will remain the same and the equity beta will rise.
C. the asset beta will decline and the equity beta will also decline.

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Solutions

B is correct. Asset risk does not change with a higher debt-to-equity ratio. Equity risk
rises with higher debt.

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j. Describe uses of country risk premiums in estimating the cost of equity

QUESTIONS 20

Which of the following is least likely to be a component of a developing country’s equity

premium?
A. Annualized standard deviation of the developing country’s equity index
B. Sovereign yield spread
C. Annualized standard deviation of the sovereign bond market in terms of the
developing country’s currency

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Solution

C is correct. The annualized standard deviation of the sovereign bond market in terms
of the developing country’s currency is not part of the equity premium calculation.
Country equity premium = Sovereign yield spread × (Annualized standard deviation
of equity index/Annualized standard deviation of the sovereign bond market in terms
of the developed market currency)

A is incorrect because the annualized standard deviation on a developing country’s

index is part of the country’s equity premium.

B is incorrect because the sovereign yield spread is part of the country equity premium.

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j. Describe uses of country risk premiums in estimating the cost of equity

QUESTIONS 21

Cyndi collects data related to a company called Dinah Ltd. The asset beta of the
company equals 0.64 while the equity beta is 1.80. Given that the tax rate is 40%, the
percentage of capital funded by debt is closest to:
A. 30%
B. 75%
C. 80%

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Solutions

B is correct. –
 D
% of debt = βE  βA  1   1  t  
 E 
  D 
1.8  0.64 1   1  0.4    
  E 
3.02
% of debt   75%
3.02  1

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j. Describe uses of country risk premiums in estimating the cost of equity.

QUESTIONS 22

An analyst has collected following information about a private company and its
publicly traded competitor:
Comparable Companies Tax Rate (%) Debt/Equity Equity Beta
Private company 35.0 0.90 N.A.
Public company 30.0 0.70 1.15
Using the pure-play method, the estimated equity beta for the private company is
closest to:
A. 2.221
B. 3.221
C. 1.223

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Solutions

C is correct.
The asset (unlevered) beta for the public company is calculated as follows:
1.15
 0.772
1   1  0.30  0.70  
Now calculating the levered beta for the private firm using its target debt ratio:
0.772  1   1  0.35  0.90  
= 1.223.

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j. Describe uses of country risk premiums in estimating the cost of equity.

QUESTIONS 23

An analyst has gathered the following information about the capital markets in the U.S.
and in Montila, a developing country.

Selected Market Information (%)

Yield on U.S. 10-year Treasury bond 6.5
Yield on Montila, 10-year government bond 12.5
Annualized standard deviation of Montila stock index 40.0
Annualized standard deviation of Montila dollar-denominated 25.0
government bond
Based on the analyst’s data, the estimated country equity premium for Montila is closest
to:
A. 8.41%
B. 9.60%
C. 10.40%

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Solutions

B is correct.
The country equity premium can be estimated as the sovereign yield spread times the
volatility of the country’s stock market relative to its bond market.
 0.4 
Montila’s equity premium =  0.125  0.065     6%  1.6  9.60%
 .25 

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k. Describe the marginal cost of capital schedule, explain why it may be upward-
sloping with respect to additional capital, and calculate and interpret its break-
points.

QUESTIONS 24

Which of the following is least likely a reason why the marginal cost of capital schedule
for a company rises as additional funds are raised?
A. The company seeks to issue less senior debt because it violates the debt incurrence
test of an existing debt covenant.
B. The company deviates from its target capital structure because of the economies of
scale associated with flotation costs and market conditions.
C. When funds are raised lumpsum, firm enjoys economics of scale resulting in lower
cost as additional funds are raised.

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Solutions

C is correct.
As per C, WACC should fall as additional funds are raised.

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k. Describe the marginal cost of capital schedule, explain why it may be upward-
sloping with respect to additional capital, and calculate and interpret its break-
points.

QUESTIONS 25

Analyst 1: Using the adjustment for the flotation costs in the cost of capital may be
useful if specific project financing cannot be identified.

Analyst 2: By adjusting the cost of capital for the flotation costs, it is easier to
demonstrate how costs of financing a company change as a company exhausts
internally generated equity (i.e., retained earnings) and switches to externally
generated equity.

Which analyst’s statements is (are) most likely correct?

A. Analyst 1.
B. Analyst 2.
C. Both.

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Solution

C is correct.
Both statements on why we see the adjustment of floatation costs in the cost of capital
instead of the net present value calculation are correct.

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The following information related to Questions 26 - 31

Shawn Miller, CFA, is a buy-side analyst for a foundation managing a global large-cap fund. He
has hired the services of a telecommunications industry expert, Phillipa Jenkens. Miller is
analyzing one of the fund’s largest holdings, a mobile phone manufacturer Satellite QS operating
globally in 50 countries with historical global revenues of $12.4 billion. Recently, Satellite’s
management announced expansion plans for a green field investment in Indonesia. Miller is
concerned about the implications of the expansion plans on Satellite’s risk profile and is
wondering whether he should issue a ‘sell’ recommendation on the fund holding.

Miller provides Jenkens with basic company information. Satellite’s global annual free cash flow
to the firm is $700 million, which is expected to level off at a 3.5 percent growth rate and earnings
are $550 million. Miller estimates that Satellite’s after-tax free cash flows to the firm on the
Indonesia project for the next four years are $60 million, $64 million, $67.5 million and $70.4
million. The company has just recently announced a dividend of $2.5 per share of stock. To keep
the analysis simple, Miller asks Jenkens to ignore any possible exchange rate fluctuations. For the
first four years, the Indonesian plant is expected to serve Indonesian customers only. Jenkens has
been assigned to evaluate Satellite’s financing plans of $130 million with a $97.50 million public
offering of 8-year debt in the US and the remainder to be financed by means of equity offering

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Additional information:.

Equity risk premium, US 3.20 percent

Risk-free rate of interest, US 1.50 percent
Industry debt-to-equity ratio 0.45
Market value of Satellite’s debt $750 million
Market value of Satellite’s equity $3.2 billion
Satellite’s equity beta 1.05
Satellite’s before-tax cost of debt 5.25 percent
Indonesia credit A2 country risk 4.58 percent
premium
Corporate tax rate 35 percent
Interest payments each year Level

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QUESTIONS 26

Satellite’s cost of equity capital for a typical project using the capital asset pricing
model is closest to:
A. 2.94 percent.
B. 4.59 percent.
C. 4.86 percent.

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Solution

C is correct.
re  0.0150   1.05  0.0320   0.0486 or 4.86%

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QUESTIONS 27

The weighted average cost of capital of Satellite QS prior to investing in Indonesia is

closest to:
A. 2.94 percent.
B. 4.59 percent.
C. 4.86 percent.

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Solution

B is correct.
 $750    $3, 200  
WACC     0.0525  1  0.35        0.0486    0.0459 or 4.59%
 $3,950    $3,950  

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QUESTIONS 28

In estimating the project’s cost of capital, the estimated asset beta of Satellite QS
prior to investing in Indonesia is closest to:
A. 0.911.
B. 0.915.
C. 1.302.

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Solution

A is correct.
1.05
Asset beta = Unlevered beta   0.911
  $750  
1   1  0.35   
  $3, 200  

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QUESTIONS 29

Miller wants to conduct sensitivity analysis for the effect of the new project on
the company’s cost of capital. The estimated project beta for Indonesia project if
it is financed with 75% with debt and has the same asset risk as Satellite, is closest to:
A. 3.841.
B. 2.699.
C. 2.688.

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Solution

C is correct.
   $97.5   
Project beta =  1   1  0.35       0.9112.96  2.688
   $32.5   

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QUESTIONS 30

The cost of equity capital for the Indonesia project considering that this project
requires to capture the country risk premium, that would form part of the sensitivity
analysis that Miller wants to conduct for the effect of the new project on the company’s
cost of capital, is closest to:
A. 22.41 percent.
B. 23.17 percent.
C. 26.87 percent.

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Solution

A is correct.
re  0.0150  2.688  0.0320  0.0458   0.2241 or 22.41%

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QUESTIONS 31

In the final presentation to the senior fund manager, Miller wants to discuss the
sensitivity of the project’s NPV to the estimation of the cost of equity. The
Indonesia project’s NPV calculated without the country risk premium and with
the country risk premium are, respectively:
A. $95 million and $73 million.
B. $101 million and $85 million.
C. $101 million and $73 million.

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Solution

B is correct.
Cost of equity without the country risk premium:
re  0.0150  2.688  0.0320   0.1010 or 10.10%
Cost of equity with the country risk premium:
re  0.0150  2.688  0.0320  0.0458   0.2241 or 22.41%
Weighted average cost of capital without the country premium:
WACC = [0.75(0.0525) (1 – 0.35)] + [0.25(0.1010)] = 0.0508 or 5.08%
Weighted average cost of capital with the country premium:
WACC = [0.75(0.0525) (1 – 0.35)] + [0.25(0.2241)] = 0.0816 or 8.16%

NPV without the country risk premium:

Enter the following values in a financial calculator to calculate the NPV:
CF0 = -130, CF1 = 60, CF2=64, CF3=67.5, CF4 = 70.4, I = 5.08, CPT NPV; NPV = 100.97

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NPV with the country risk premium:
Enter the following values in a financial calculator to calculate the NPV:
CF0 = -130, CF1 = 60, CF2=64, CF3=67.5, CF4 = 70.4, I = 8.16, CPT NPV; NPV = 84.96

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