2.1. Suppose stock in Watta Corporation has a beta of 0.80.

The market risk premium is 6

percent, and the risk-free rate is 6 percent. Watta’s last dividend was $1.20 per share, and the
dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $45 per share.
What is Watta’s cost of equity capital?

2.2. In addition to the information given in the previous problem, suppose Watta has a target
debt-equity ratio of 50 percent. Its cost of debt is 9 percent before taxes. If the tax rate is 35
percent, what is the WACC?

2.3. The Down and Out Co. just issued a dividend of $2.40 per share on its common stock. The
company is expected to maintain a constant 5.5 percent growth rate in its dividends indefinitely.
If the stock sells for $52 a share, what is the company’s cost of equity?

2.4. The Up and Coming Corporation’s common stock has a beta of 1.05. If the risk-free rate is
5.3 percent and the expected return on the market is 12 percent, what is the company’s cost of
equity capital?

2.5. Stock in Country Road Industries has a beta of 0.85. The market risk premium is 8 percent,
and T-bills are currently yielding 5 percent. The company’s most recent dividend was $1.60 per
share, and dividends are expected to grow at a 6 percent annual rate indefinitely. If the stock sells
for $37 per share, what is your best estimate of the company’s cost of equity?

2.6. Holdup Bank has an issue of preferred stock with a $6 stated dividend that just sold for $96
per share. What is the bank’s cost of preferred stock?

2.7. Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent
preferred stock, and 35 percent debt. Its cost of equity is 14 percent, the cost of preferred stock is
6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent.

a. What is Mullineaux’s WACC?

b. The company president has approached you about Mullineaux’s capital structure. He wants to
know why the company doesn’t use more preferred stock financing because it costs less than
debt. What would you tell the president?

2.8. Sixx AM Manufacturing has a target debt-equity ratio of 0.65. Its cost of equity is 15
percent, and its cost of debt is 9 percent. If the tax rate is 35 percent, what is the company’s
WACC?

1
2.9. Fama’s Llamas has a weighted average cost of capital of 8.9 percent. The company’s cost of
equity is 12 percent, and its pretax cost of debt is 7.9 percent. The tax rate is 35 percent. What is
the company’s target debt-equity ratio?

2.10. Jungle, Inc., has a target debt-equity ratio of 1.05. Its WACC is 9.4 percent, and the tax rate
is 35 percent.

a. If Jungle’s cost of equity is 14 percent, what is its pretax cost of debt?

b. If instead you know that the after-tax cost of debt is 6.8 percent, what is the cost of equity?

2.11. Floyd Industries stock has a beta of 1.50. The company just paid a dividend of $.80, and the
dividends are expected to grow at 5 percent. The expected return of the market is 12 percent, and
Treasury bills are yielding 5.5 percent. The most recent stock price for Floyd is $61.

a. Calculate the cost of equity using the DCF method.

b. Calculate the cost of equity using the SML method.

c. Why do you think your estimates in (a) and (b) are so different?

2.12. Hook Industries’ capital structure consists solely of debt and common equity. It can issue
debt at rd = 11% and its common stock currently pays a $2.00 dividend per share. The stock’s
price is currently $24.75, its dividend is expected to grow at a constant rate of 7% per year, its tax
rate is 35% and its WACC is 13.95%. What percentage of the company’s capital structure
consists of debt?

2.13. Maynard, Inc., has no debt outstanding and a total market value of $250,000. Earnings
before interest and taxes, EBIT, are projected to be $28,000 if economic conditions are normal. If
there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a
recession, then EBIT will be 50 percent lower. Maynard is considering a $90,000 debt issue with
a 7 percent interest rate. The proceeds will be used to repurchase shares of stock. There are
currently 5,000 shares outstanding. Ignore taxes for this problem.

a. Calculate earnings per share (EPS) under each of the three economic scenarios before any debt
is issued. Also calculate the percentage changes in EPS when the economy expands or enters a
recession.

2
b. Repeat part (a) assuming that the company goes through with recapitalization. What do you
observe?

2.14. Repeat parts (a) and (b) in Problem 2.13 assuming Maynard has a tax rate of 35 percent.

2.15. James Corporation is comparing two different capital structures: an all-equity plan (Plan I)
and a levered plan (Plan II). Under Plan I, the company would have 160,000 shares of stock
outstanding. Under Plan II, there would be 80,000 shares of stock outstanding and $2.8 million in
debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes.

a. If EBIT is $350,000, which plan will result in the higher EPS?

b. If EBIT is $500,000, which plan will result in the higher EPS?

c. What is the break-even EBIT?

2.16. A company’s fixed operating costs are $500,000, its variable costs are $3.00 per unit, and
the product’s sales price is $4.00. What is the company’s breakeven point; that is, at what unit
sales volume will its income equal its costs?

2.17. The Watch Company sells watches for $25, the fixed costs are $140,000 and variable costs
are $15 per watch.

a. What is the firm’s gain or loss at sales of 8,000 watches? at sales of 18,000 watches?

b. What is breakeven point?

c. What would happen to the breakeven point if the selling price was raised to $31? What is the
significance of this analysis?

d. What would happen to the breakeven point if the selling price was raised to $31 but the
variable costs raised to $23 a unit?