CORPORATE FINANCE (FIN3004) – Semester 1, 2020

Tutorial 2

Question 1
How would each of the following scenarios affect a firm’s cost of debt,
rd(1 – T); its cost of equity, rs; and its WACC? Indicate by a plus (+), a
minus (-), or a zero (0) if the factor would raise, would lower, or would
have an indeterminate effect on the item in question. Assume for each
answer that other things are held constant, even though in some
instances this would probably not be true.

A good way to evaluate the effects on the various costs of capital concepts is
to think about the techniques (methods) that can be used to calculate them:

Effect On
rd(1 – T) rs WACC
a. The corporate tax rate is lowered. + 0 +
b. The Federal Reserve tightens credit. + + +
c. The firm uses more debt; that is, it increases + + 0
its debt/assets ratio.
d. The dividend payout ratio is increased. 0 0 0
e. The firm doubles the amount of capital it 0 or + 0 or + 0 or +
raises during the year.
f. The firm expands into a risky new area. + + +
g. The firm merges with another firm whose - - -
earnings are countercyclical both to those of the
first firm and to the stock market.
h. The stock market falls drastically, and the 0 + +
firm’s stock price falls along with the rest.
i. Investors become more risk averse. + + +
j. The firm is an electric utility with a large + + +
investment in nuclear plants. Several states are
considering a ban on nuclear power generation.

Brief explanations for each are as follows:

a. The corporate tax rate is lowered

- A decrease in the tax rate (T) will increase rd(1 – T) obviously
- It is not clear that a decrease in the corporate tax rate will influence the cost
of equity, although if the increase in after-tax earnings allows firms to pay
higher dividends then, other things equal, this will increase rs using the
discounted cash flow approach
- If rd(1 – T) increases and rs is unchanged or increases, then the WACC will
increase

b. The Federal Reserve tightens credit

- The Federal Reserve will tighten credit by increasing the benchmark
interest rate (the Federal funds rate) which will flow through to increase
lending rates generally and the cost or debt (rd) in the market
- If we calculate rs using the cost of debt plus risk premium method, then an
increase in the cost of debt will increase the cost of equity (rs). Similarly, an
increase in the benchmark rate will increase the risk-free rate, leading to a
higher rs using the capital asset pricing model (CAPM)
- If rd and rs increase, then the WACC will also increase

c. The firm uses more debt, that is, it increases its debt/assets ratio
- As a firm adds more debt, its financial and default risk increases, so new,
and potentially existing debt providers, will demand a higher return to
compensate for the increased risk exposure, thus, increasing rd
- Shareholders will also demand a higher return in response to an increase in
overall debt (this is known as the implicit cost of debt), thus they will
increase rs
- If rd and rs increase, then the WACC may also increase, however, the
greater use of the lower cost source of finance (debt) may offset the increase
in rs, making the final impact on the firm WACC uncertain

d. The dividend payout ratio is increased

- This should have no obvious impact on r d, although greater dividend
payouts may remove more funds (available cash) from the firm and increase
the likelihood of defaulting on a debt payment, which would increase rd
- If we think about the discounted cash flow approach, a dividend increase
will increase the dividend yield (D1/P0), but decrease the growth rate as the
retention rate will decrease, so the ultimate impact on rs is indeterminate
- If the impact on rd and rs is uncertain, then the impact on WACC is difficult
to determine also

e. The firm doubles the amount of capital it raises during the year.
- The effects of this depend on what type of capital (debt or equity) is raised
or what overall capital structure is used, and the uses that this capital is put
to (risk profile and profitability of investments etc.).
- If it is predominantly debt capital that is issues, then the outcome will be
similar to part c.
- If the firm issues new equity, then the cost of new common equity (r e) will
be higher than rs, but this may not influence rs directly.
- Depending on what happens to rd, the WACC may increase due to the
addition of the weighted component associated with the higher re

f. The firm expands into a risky new area

- Increased risk implies greater uncertainty regarding whether the firm will
be able to meet contractual payments to debtholders, leading to debtholders
raising their required return (rd)
- Stockholders will also increase their required return (rs) in response to a
general increase in the risk level of the firm and an increase in rd

g. The firm mergers with another firm whose earnings are countercyclical
both to those of the first firm and to the stock market
- This will have a diversifying (smoothing) effect on the earnings of the
firm, which should reduce the risk of earnings fluctuation and uncertainty
regarding the firm’s ability to make payments, thus, reducing rd
- A decrease in firm risk, and adding earnings which are countercyclical to
the market, should lower the firm’s beta coefficient which will reduce r s
calculated using the CAPM
- If rd and rs decrease, then the WACC should also decrease

h. The stock market falls drastically, and the firm’s stock price falls along
with the rest.
- There is no reference to the firm having listed debt, so this influence is
indeterminate. If there is a switch from investment in the stock market to the
bond market, this will increase demand for (and prices of) debt securities
and drive downward yields (required returns), but may not impact on the r d
of existing firm debt
- Using the discounted cash flow approach, if the stock price falls then the
dividend yield (D1/P0) increases and, assuming no change in the firm’s
growth rate, rs will increase
- If rs increases, and rd either is unchanged or increases, with no change in
underlying capital structure weights, then the WACC would be expected to
increase
i. Investors become more risk averse.
- An increase in the general level of risk aversion by investors will lead to
them increasing their required returns on all forms of assets, which should
flow through to increase both rd on debt securities and rs on equity securities
- If rd and rs both increase, then the firm WACC will also increase

j. The firm is an electric utility with a large investment in nuclear plants.

Several states are considering a ban on nuclear power generation.
- A ban on nuclear power may lead to the shut-down of some of the
company’s plants or, at least, a reduction in demand for their product and
therefore revenues and profits. This will increase the uncertainty about the
firm’s financial stability and ability to meet ongoing debt payments. This
will increase the risk of the firm’s debt and lead to an increase in rd
- The impact on such a ban would likely lower the firm’s share price, which
would increase the dividend yield and the firm’s rs if its growth rate remains
unchanged. Similarly, an increase in the cost of debt (rd) will increase rs
using the cost of debt plus risk premium approach, with the firm’s risk
premium potentially also being increased based on this shock to its operating
environment.
- If rd and rs both increase, then the firm WACC will also increase
Problem 1
The future earnings, dividends, and common stock price of Carpetto
Technologies Inc. are expected to grow 7% per year. Carpetto’s
common stock currently sells for $23.00 per share; its last dividend was
$2.00, and it will pay a $2.14 dividend at the end of the current year.
a) Using the DCF approach, what is its cost of common equity?

Cost of common equity (rS) = $2.14 / $23.00 + 0.07 = 0.1630 (16.30%)

b) If the firm’s beta is 1.6, the risk-free rate is 9%, and the average
return on the market is 13%, what will be the firm’s cost of common
equity using the CAPM approach?

Cost of common equity (rS) = 0.09 + (0.13 – 0.09)(1.60) = 0.1540 (15.40%)

c) If the firm’s bonds earn a return of 12%, 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? (Section 10-5b suggests using a risk premium range of
3% to 5%).

The suggested appropriate risk premium range in the Brigham and Houston
(2013) textbook is from 3% to 5%. The mid-point of this range would,
therefore, be a risk premium (RP) of 4%.

Cost of common equity (rS) = 0.12 + 0.04 = 0.16 (16.00%)

d) If you have equal confidence in the inputs used for the three
approaches, what is your estimate of Carpetto’s cost of common
equity?

Equal confidence implies equal weighting being given to each of the

estimates, and an overall estimate of the firm’s cost of common equity can
be calculated as an average across the estimates:
Cost of common equity (rS) = (0.1630 + 0.1540 + 0.1600) / 3 = 0.1590
(15.90%)
Problem 2 (WACC)
Klose Outfitters Inc. believes that its optimal capital structure consists
of 60% common equity and 40% debt, and its tax rate is 40%. Klose
must raise additional capital to fund its upcoming expansion. The firm
will have $2 million of new retained earnings with a cost of rs = 12%.
New common stock in an amount up to $6 million would have a cost of
re = 15%. Furthermore, Klose can raise up to $3 million of debt at an
interest rate of rd = 10% and an additional $4 million in debt at rd =
12%. The CFO estimates that a proposed expansion would require an
investment of $5.9 million. What is the WACC for the last dollar raised
to complete the expansion?
Based on the firm’s indicated optimal capital structure mix of 60% equity
and 40% debt financing, the $5.9 million expansion should be funded in the
following proportions:
• Equity financing = $5.9 million × 0.60 = $3.54 million
• Debt financing = $5.9 million × 0.40 = $2.36 million

Equity financing components to total $3.54 million:

1) $2 million of retained earnings at a cost of retained earnings (rs) = 12% –
Weight for retained earnings (ws) = $2 million / $5.9 million = 0.3390
2) $1.54 million of new common stock at a cost of new common stock (re) =
15% – Weight for new common stock (we) = $1.54 million / $5.9 million
= 0.2610

Debt financing component to total $2.36 million:

1) $2.36 million of debt at a before-tax cost of debt (rd) = 10% – Weight for
debt (wd) = $2.36 million / $5.9 million = 0.4000

The average overall WACC can be calculated as:

• Overall WACC = (wd)(rd)(1 – T) + (ws)(rs) + (we)(re)
• Overall WACC = (0.4000)(0.10)(0.60) + (0.3390)(0.12) + (0.2610)(0.15)
= 0.1038 (10.38%)
However, the WACC for the last dollar of the expansion involves issuing
40% ($0.40) debt at a cost of 10% and 60% ($0.60) new common stock at a
cost of 15%. Thus the WACC applicable to the last dollar of expansion
financing is:
• WACC for last dollar = (0.4000)(0.10)(0.60) + (0.6000)(0.15) = 0.1140
(11.40%)
Problem 3 (WACC and optimal capital budget)
Adams Corporation is considering four average-risk projects with the
following costs and rates of return:

Project Cost Expected Rate of

Return
1 $2,000 16.00%
2 $3,000 15.00%
3 $5,000 13.75%
4 $2,000 12.50%

The company estimates that it can issue debt at a rate of r d = 10%, and
its tax rate is 30%. It can issue preferred stock that pays a constant
dividend of $5.00 per year at $49.00 per share. Also, its common stock
currently sells for $36.00 per share, the next expected dividend, D 1, is
$3.50, and the dividend is expected to grow at a constant rate of 6% per
year. The target capital structure consists of 75% common stock, 15%
debt, and 10% preferred stock.
a) What is the cost of each of the capital components?

After-tax cost of debt (rd) = 0.10(1 – 0.30) = 0.0700 (7.00%)

Cost of preferred stock (rp) = $5.00 / $49.00 = 0.1020 (10.20%)
Cost of common stock (rs) = $3.50 / $36.00 + 0.06 = 0.1572 (15.72%)

b) What is Adam’s WACC?

WACC = wd(rd)(1 – T) + wp(rp) + ws(rs)

WACC = 0.15(0.07) + 0.10(0.1020) + 0.75(0.1572) = 0.1386 (13.86%)

c) Only projects with expected returns that exceed WACC will be

accepted. Which projects should Adams accept?

Adams Corporation should accept projects 1 and 2, since their expected rates
of return exceed the firm’s WACC.