Suppose Tom O$$Bedlam$,$ president of Bedlam Products, Inc., has hired you to determine the firm$$s cost

of debt and cost of equity capital. Question $1$: WACC

$(10$ points$)$ On the most basic level, if a firm$$s WACC is $12$ percent, what does this mean?

a$.(15$ points$)$ The stock currently sells for $$50$ per share, and the dividend per share will probably

be about $$5.$ Tom argues, $$It will cost us $$5$ per share to use the stockholders$$ money this year,

so the cost of equity is equal to $10$ percent $(=$ $$5/$$$50).$ What$$s wrong with this conclusion?

b$.(15$ points$)$ Based on the most recent financial statements, Bedlam Products$$ total liabilities are

$$8$ million. Total interest expense for the coming year will be about $$1$ million. Tom therefore

reasons, $$We owe $$8$ million, and we will pay $$1$ million interest. Therefore, our cost of debt is

obviously $$1$ million$/$ $$8$ million $=\mathrm{.}125,$ or $12\mathrm{.}5\%.$ What$$s wrong with this conclusion?

c$.(15$ points$)$ Based on his own analysis, Tom is recommending that the company increase its use

of equity financing, because $$Debt costs $12\mathrm{.}5$ percent, but equity only costs $10$ percent; thus

equity is cheaper.$$ Ignoring all the other issues, what do you think about the conclusion that the

cost of equity is less than the cost of debt?

Question $3$: Divisional Cost of Capital

a$.(15$ points$)$ Under what circumstances would it be appropriate for a firm to use different

costs of capital for its different operating divisions?

b$.(15$ points$)$ If the overall firm WACC was used as the hurdle rate for all divisions, would the

riskier divisions or the more conservative divisions tend to get most of the investment

projects? Why?

c$.(15$ points$)$ If you were to try to estimate the appropriate cost of capital for different

divisions, what problems might you encounter?