Measuring and Using the Cost of Capital
Problem 1: Answer the following questions
i) Your firm can borrow from its bank at a quoted rate of 8% per year. If your company is in the 35% tax bracket, what is your firm's cost of debt?
ii) The beta of your firm is 0.80. If the risk-free rate of return is currently 4.5%, and the market risk premium (Rp) is 6.5%, estimate the cost of equity for your company.
iii) If your company currently pays dividends of $2 per share, its growth rate is 6% per year, and the price of your common stock is $20 per share, estimate the cost of equity for your company.
iv) Your company's capital structure is described below:
(1) Outstanding Debt: $8 million of bank loans at an interest rate of 10% per year. Since there is really no market for bank loans, we can assume that the market value of these loans is equal to the outstanding principal.
(2) Common Stock: 1 million shares of $1 par common stock are outstanding. The market value of these shares is $12 per share. The firm's retained earnings is $8.2 million.
v) Calculate the following, assuming your firm is in the 36% tax bracket.
(1) The proportion of debt, using both market value and book value proportions.
(2) The proportion of equity, using both market value and book value proportions.
Problem 2: Cost of Capital
i) You are interested in determining the cost of capital for Hewlett-Packard Company. The company is financed with $96 billion of common stock (market value) and $5 billion of debt. Assume the interest rate on the debt is 9%, before-tax. The company's beta is 1.92, the interest rate on government bonds is currently 6%, and the historical excess return on common stocks is 6.5%. The firm is in the 34% tax bracket.
(1) Estimate their cost of capital.
(2) What is the minimum return that investors in HP common stock would find acceptable?
(3) Debt financing is much less expensive for HP. Why, then, do you suppose they have so much equity on their balance sheet?
(4) Would it ever pay for HP to make investments that earn a rate of return less than that you found above? Explain why or why