Question 1

Cost of debt using the approximation formulaFor the following $1,000-par-value bond, assuming annual interest payment and a 27% taxrate, calculate the after-tax cost to maturity using the approximation formula.

Life Underwriting fee Discount () or premium (+) Coupon interest rate

10 years $40 -$60 12%

Theafter-tax cost of financing using the approximation formula is __________%. (Round to two decimalplaces.)

Question 2

Before-tax cost of debtGronseth DrywallSystems, Inc., is in discussions with its investment bankers regarding the issuance of new bonds. The investment banker has informed the firm that different maturities will carry different coupon rates and sell at different prices. The firm must choose among several alternatives.

In eachcase, the bonds will have a $1,000 par value and flotation costs will be $40 per bond. Calculate the before-tax cost of financing with the following alternative.

Coupon rate Time to maturity Premium or discount

5% 20 years -$270

Thebefore-tax cost of debt is __________%. (Round to two decimalplaces.)

Question 3

Cost of capitalEdna RecordingStudios, Inc., reported earnings available to common stock of $4,200,000 last year. From thoseearnings, the company paid a dividend of $1.32 on each of its 1,000,000 common shares outstanding. The capital structure of the company includes 25% debt, 20% preferredstock, and 55% common stock. It is taxed at a rate of 26%.

a.If the market price of the common stock is $38 and dividends are expected to grow at a rate of 7% per year for the foreseeablefuture, what is thecompany's cost of retained earnings financing?

b.If underpricing and flotation costs on new shares of common stock amount to $7 pershare, what is thecompany's cost of new common stock financing?

c.The company can issue $2.03 dividend preferred stock for a market price of $26 per share. Flotation costs would amount to $2 per share. What is the cost of preferred stock financing?

d.The company can issue $1,000-par-value, 11% coupon, 11-year bonds that can be sold for $1,200 each. Flotation costs would amount to $20 per bond. Use the estimation formula to figure the approximateafter-tax cost of debtfinancing?

e.What is the WACC?

Question 4

Weighted average cost of capitalAmericanExploration, Inc., a natural gasproducer, is trying to decide whether to revise its target capital structure. Currently it targets a 50-50 mix of debt andequity, but it is considering a target capital structure with 70% debt. American Exploration currently has 7% after-tax cost of debt and a 14% cost of common stock. The company does not have any preferred stock outstanding.

a.What is AmericanExploration's currentWACC?

b.Assuming that its cost of debt and equity remainunchanged, what will be AmericanExploration's WACC under the revised target capitalstructure?

c.Do you think shareholders are affected by the increase in debt to 70%? Ifso, how are theyaffected? Are the common stock claims riskiernow?

d.Suppose that in response to the increase indebt, AmericanExploration's shareholders increase their required return so that cost of common equity is 18%. What will its new WACC be in thiscase?

e.What does your answer in part d suggest about the tradeoff between financing with debt versusequity?