Problem 10-10

WACC

Olsen Outfitters Inc. believes that its optimal capital structure consists of 65% common equity and 35% debt, and its tax rate is 40%. Olsen must raise additional capital to fund its upcoming expansion. The firm will have $1 million of retained earnings with a cost of rs= 12%. New common stock in an amount up to $10 million would have a cost of re= 14%. Furthermore, Olsen can raise up to $3 million of debt at an interest rate of rd= 9%, and an additional $3 million of debt at rd= 11%. The CFO estimates that a proposed expansion would require an investment of $7.3 million. What is the WACC for the last dollar raised to complete the expansion? Round your answer to two decimal places.

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd= 11% as long as it finances at its target capital structure, which calls for 40% debt and 60% common equity. Its last dividend (D0) was $3.05, its expected constant growth rate is 3%, 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 13%, and Project B's return is 8%. These two projects are equally risky and about as risky as the firm's existing assets.

1. What is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.

%

1. What is the WACC? Round your answer to two decimal places. Do not round your intermediate calculations.

%

1. Which projects should Empire accept?

-Select-

1. Project A
2. Project B

Problem 10-6

Cost of Common Equity

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan's common stock currently sells for $22.00 per share; its last dividend was $2.00; and it will pay a $2.12 dividend at the end of the current year.

1. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
2. %
3. If the firm's beta is 1.60, the risk-free rate is 6%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
4. %
5. If the firm's bonds earn a return of 8%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.
6. %
7. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
8. %