DEF plc. is a leading producer of mountain sports equipment. The company is

currently evaluating a new product: self-heating hiking boots. The CEO and her team

have already estimated the projects cash flows and the initial cost required for the

project is 5,000,000. The company will finance the project by issuing corporate

bonds worth of 1,500,000, issuing preferred stock worth of 500,000 and the

remaining 3,000,000 will be financed from retained earnings. Also note that:

(1) DEF has recently issued a 15-year, 6% coupon corporate bond, that pays

coupon twice per year. The bond face value is 1,000 and the price is 954.

(2) The firm uses short-term debt of 200,000 to finance working capital

requirements.

(3) The companys preferred stock is traded at 4.50, pays 30% of 1 par as

annual dividend, twice per year. In case DEF issues new preferred stock,

issuance costs will be 5%.

(4) Government bonds currently offer 2%, and the market risk premium is

estimated at 6%. The firms beta is 1.3.

(5) DEF last dividend (D0) to common shareholders was 0.35, having steadily

increased from 0.28 four years ago. DEFs current common stock price is

11.

(6) DEFs tax rate is 20 percent.

Questions

1. Should you include all capital items (common stock, preferred stock, corporate

bonds, long- and short-term debt) while calculating the DEFs weighted average

cost of capital (WACC)?

2. a. Calculate DEFs cost of debt.

b. In case DEFs debt was not traded, could you think of other methods to

estimate cost of debt?

3. Calculate DEFs cost of preferred stock.

4. a. Describe the theoretical rationale behind the cost of retained earnings.

b. Calculate DEFs cost of retained earnings using the CAPM approach. Should

you use long-term or short-term government bonds as the best estimate of the riskfree

rate? Explain.

5. Calculate DEFs cost of retained earnings using the DDM approach

6. What is your final estimate for the cost of retained earnings? Explain.

7. Calculate DEFs weighted average cost of capital (WACC).

Part B (10%)

Assume that DEF plc. has several production divisions, each one producing different

products. Should the overall WACC as calculated in (7) above be used for all these

divisions? Analyze.