Chapter 10

OCF, how are taxes calculated?

T x (Sales – COGS – SG&A – Depr)
Calculate Operating Cash Flow

Operating Cash Flow

OCF = Sales – COGS – SG&A – Taxes

T% x (Sales – COGS – SG&A – Depr) = 559460
=2, 570, 540
Calculate Operating Cash Flow (Depreciation is Tax Deductible)
EBITA = Net income + Depreciation + Interest + Taxes
T = Taxes / Income before Taxes

OCF = Sales – COGS – SG&A – Taxes

↓
OCF = EBITA x (1-T) + (T x Depr)
- For T, use the decimal calculated above, keep 4 or 5 decimals (Taxes/Income before
Taxes)

Calculate Operating Cash Flow (Depreciation is NOT Tax Deductible)

EBITA = Net income + Depreciation + Interest + Taxes
T = Taxes / Income before Taxes

OCF = EBITA x (1-T)

Change in Net Working Capital (NWC)

Change in NWC = Change in Current Assets – Change in Current Liabilities
So…
Change in NWC = Inventory – Accrued Liabilities – Accounts Payable

Investment in Net Working Capital in Year 1

Change in NWC = Change in Current Assets – Change in Current Liabilities

Free Cash Flow in Year 1

OCF = EBITA x (1-T) + (T x Depr)
Change in NWC = Change in Current Assets – Change in Current Liabilities
Free Cash Flow = OCF – Change in NWC – CAPEX
Initial Cash Flows
CAPEX = purchasing equipment, installation costs etc.
Inc (Dec) in NWC = did you buy or sell inventory? + / -
- “Machine will require an increase in NWC of $____” = subtract NWC

FCF0 = 0 – CAPEX – Inc (Dec) in NWC

Terminal Cash Year Flows (Depreciation is NOT Tax Deductible)

FCFT = OCF + Decrease in NWC (inventory) + Salvage

Determine If the Project is Worth Undertaking (Depreciation is NOT Tax Deductible)

18. Dr. Hunter Thompson is considering opening an MRI clinic in Aspen. The business will
operate for three years. The MRI machine, a GE, costs $2.6M and will be delivered immediately.
The machine can be sold for $500,000 at the end of the three years. Dr. Thompson estimates that
he can perform 2,500 scans annually at $700 per scan for $1.75M of annual revenues. Dr.
Thompson will lease office space in a local strip-mall and estimates that annual operating
expenses will be $550,000 (including rent, salaries, and wages). Dr. Thompson plans to offer
credit to his customers. He expects to have about 45 days of sales in accounts receivable, or
about $300,000. He has arranged venture funding from Oscar Acosta who expects a return of
10% on his invested capital. The tax rate is 35%. Answer the following questions to determine if
the project is worth undertaking. (Assume that depreciation is not tax deductible.)
Initial Cash Flows for Project
FCF0 = 0 – CAPEX – Inc (Dec) in NWC
FCF0 = 0 – 2 600 000 – 300 000
FCF0 = - 2 900 000

OCF in Year 1
EBITA = Revenues – Expenses
EBITA = 1 750 000 – 550 000
EBITA = 1 200 000

OCF = EBITA x (1-T)

OCF = 1 200 000 x (1 - 0.35)
OCF = 780 000

Terminal Cash Flows

FCFT = OCF + Decrease in NWC (inventory) + Salvage
FCFT = 780 000 + 300 000 + 500 000
FCFT = 1 580 000

NPV of the Project

OCF in Year 1 (Cost of Buying New Machine is Tax Deductible)

19. Mike Mulligan Excavation Inc. is considering the purchase of a new Caterpillar 345DL
Hydraulic Excavator. The machine will be used for two years to excavate building foundations.
The cost of the machine is $350,000 and it can be sold for $100,000 at the end of two years.
Mike estimates that, with the new machine, he can dig 35 foundations per year with an average
invoice price of $12,000. Mike estimates that his incremental costs will be $150,000 per year (for
wages, fuel & maintenance). The company's cost of capital is 9% and the marginal tax rate is
35%. What are the operating cash flows in Year 1? Assume that the cost of buying the new
excavator is tax deductible at the end of the first year. (Round to the nearest dollar.

OCF in Year 1 (Depreciation is NOT Tax Deductible)

20. Ken Smith wants to start a deck and fence company. To start the business, Ken plans to invest
$70,000 in pick-up trucks and tools. Ken is forecasting that he will build 100 decks in the first
year and 120 decks in years 2 and 3. He anticipates that the average deck will be priced at
$5,500. Ken estimates that the cost of lumber for the typical deck is $2,000. Ken estimates that
rent, office expenses, vehicle expenses, wages and salaries will total $351,400 per year. The
corporate tax rate is 30%. What are operating cash flows in the first year? (Assume that
depreciation is not tax deductible.) Round your answers to the nearest dollar.

EBITA = Revenue – Costs – Expenses

EBITA = (100 x 5500) – (100 x 2000) – 351 400
EBITA = - 1400

OCF1 = EBITA x (1-T)

OCF1 = -1400 x (1 – 0.3)
OCF1 = -980
Terminal Cash Flows (Depreciation is NOT Tax Deductible)
21. Ken Smith wants to start a deck and fence company. To start the business, Ken plans to invest
$70,000 in pick-up trucks and tools. Ken is forecasting that he will build 100 decks in the first
year and 120 decks in years 2 and 3. He anticipates that the average deck will be priced at
$6,000. Ken estimates that the cost of lumber for the typical deck is $2,000. Rent, office
expenses, vehicle expenses, wages and salaries will total $350,000 per year. Ken plans to carry
an inventory of lumber of $25,000. At the end of three years, Ken thinks that he can sell the
trucks for $10,000, but the tools will be worthless. The corporate tax rate is 30%. What are the
terminal year cash flows? (Assume that depreciation is not tax deductible.) Round your answers
to the nearest dollar.

EBITA = Revenues – Costs – Expenses

EBITA = (120 x 6000) – (120 x 2000) – 350 000
EBITA = 130 000

OCF3 = EBITA x (1-T)

OCF3 = 130 000 x (1- 0.3)
OCF3 = 91 000

FCFT = OCF3 + Decrease in NWC (inventory) + Salvage

FCFT = 91 000 + 25000 + 10000
FCFT = 126 000

OCF in Year 1 and Terminal Cash Flows (Depreciation is NOT Tax Deductible)
Old Tom Morrison Golf Inc. is evaluating a new product: high compression golf balls. The ball is
tentatively called the "Guttie." The production line for the Guttie would be set up in an unused
section of Morrison’s main plant. The machinery will cost $240,000. Morrison’s inventories
would have to be increased by $30,000 to handle the new line. The project is expected to last 2
years with estimated EBITDA of $200,000 in each year. The machinery has an expected salvage
value of $40,000 at the end of two years. Robertson’s tax rate is 30%. What are operating cash
flows in the first year? (Assume that depreciation is not tax deductible.) Round your answers to
the nearest dollar.
OCF1 = EBITA x (1-T)
OCF1 = 200 000 x (1- 0.3)
OCF1 = 140 000

FCFT = OCF2 + Decrease in NWC (inventory) + Salvage

FCFT = 140 000 + 30 000 + 40 000
FCFT = 210 000

Initial Cash Flows for Replacement

26. The Rumpel Company purchased a felt press last year at a cost of $7,500. The machine has
worn out quickly and is slowing production. It could be sold today for $4,000. The division
manager reports that, for $12,000 (including installation), a new felt press can be bought. Two
years after replacement the old press can be sold for $200, and the new press will be worth
$2,000. The new press will increase EBITDA by $7,000, but to sustain the higher rate of
production, the company will need additional felt inventory of $3,000. Taxes are 40%. Assume
that depreciation is not tax deductible. What are the initial cash flows for the replacement?
(Answer in dollars and round to the nearest dollar.) Assume that depreciation is not tax
deductible. The tax rate is 40%. Use this information to answer the following questions.
Initial Cash Flows
FCF0 = - PriceNew – Inc (Dec) in NWC + SalvageOld
- “it could be sold today for $____” = SalvageOld
FCF0 = - 12 000 – 3000 + 4000
FCF0 = - 11 000

OCF in Year 1
OCF1= EBITA x (1-T)
OCF1 = 7000 x (1 - 0.4)
OCF1 = 4200

Terminal Cash Flows

FCFT = OCF + Decrease in NWC (inventory) + SalvageNew - SalvageOld
FCFT = 4200 + 3000 + 2000 – 200
FCFT = 9000

Incremental Depreciation Expense (end of first year) after Replacement

68. The Rumpel Felt Company purchased a felt press last year at a cost of $15,000. The division manager
reports that for $12,000 (including installation), a new felt press can be bought. Both machines are in
Class 43 with a 30% depreciation rate. The old machine's current market value is $10,000. What is the
incremental depreciation expense at the end of the first year after the replacement?
Incremental OCF (end of first year) after Replacement
69. The Rumpel Felt Company purchased a felt press last year at a cost of $15,000. The division manager
reports that for $13,000 (including installation), a new felt press can be bought. Both machines are in
Class 43 with a 30% depreciation rate. The old machine's current market value is $12,000. If the press is
replaced, then the incremental depreciation expense in the first year of operations is expected to be
$150. The new felt press will expand sales from $10,000 to $13,000 a year because the new fashion is for
smoother felt. Furthermore, it will reduce labor and raw materials usage sufficiently to cut operating
costs from $7,000 to $5,000. Taxes are 40%. What are the incremental operating cash flows at the end of
the first year after the replacement?
Revenues increased but Expenses decreased, so EBITDA
is like 3000 + 2000 gained in expense cuts = 5000

Revised NPV for a Project

30. The Sopwith Aviation Company is considering building a new short-range commuter jet,
code named ‘Sky Streak.’ The aircraft’s engines will be powered by a new green energy source:
high-tension elastomer. The project is expected to last three years. Selected cash flows for the
project are summarized in the table below. Sopwith’s tax rate is 34% and its cost of capital is
12%. The NPV of the project is $242.86M

The Sky Streak project is expected to reduce sales of Sopwith’s other commuter jet, the Sopwith
Camel, as some airlines choose the new, more environmentally friendly Sky Streak over the
older Camel. The lost Camel sales are expected to reduce operating cash flows by $90M per year
for the three years of the Sky Streak project. Given this information, what is the revised NPV for
the Sky Streak project? (Express your answer in millions of dollars rounded to two decimal
places.)

This is an example of negative externalities or ‘cannibalization.’ The present value of the lost
after-tax cash flows should be deducted from the NPV of the Sky Streak project. The present
value of the cash flows lost from reduced sales of the Camel are as follows. The NPV of the
project with the externalities is:

NPVNEW = NPVOLD – PV of foregone OCF

The PV of the foregone OCF is:

The CFO of Sopwith, Eamon Wright, argues that fixed costs for the Sky Streak project should include an allocation
for head office costs. Head office activities include communications, engineering, operations, finance, government
liaison, human resources, and legal services. In the last fiscal year, head office accounted for approximately 19% of
Sopwith’s total employment. The table, below, shows Sopwith’s sales, employment and head office costs for the
most recent fiscal year (without Sky Streak) and a forecast of the levels with the Sky Streak project.
Since Sky Streak is projected to account for 8% of Sopwith’s total sales, Eamon argues that Sky Streak should
include 8% of Sopwith’s head office costs in the calculation of the NPV. Eamon argues as follows: “If none of
Sopwith’s projects include an allowance for head office costs, then how can those costs be covered?”
Is Eamon’s approach correct? What is the NPV for the Sky Streak project with head office costs properly
included? (Express your answer in millions of dollars rounded to two decimal places.)

NPV of Replacement Chain Technique

37. Huck Long is the VP of production at Discraft Inc., manufacturer of freestyle, golf, and
ultimate discs. The R&D team has designed a new 175gram ultimate disc that can fly 10%
further than the old design. The manufacturing process requires a new stamping machine. Huck
is considering two alternative machines: Machine A and Machine B. Machine A costs $75,000
and stamps at a high speed but wears out after two years. Huck estimates that Machine A can
produce after-tax cash flow of $50,000 at the end of each of the two years. Machine B also costs
$75,000, but it stamps at a slower speed and can last four years. Huck estimates that it will
produce after-tax cash flow of $30,000 at the end of the next 4 years. Discraft’s cost of capital is
12%. Use the replacement chain technique to compare the two alternatives. What is the NPV of
each chain, and which should Huck choose?

17.078 x 1000 = 17078

Annual Depreciation Expense in the First Year

44. The Vogons are evaluating a new planet demolition machine that costs $19 million. The
machine falls in Class 43 with a depreciation rate of 30%. What is the annual depreciation
expense in the first year? Express your answer in millions of dollars rounded to two decimal
places.

Depr = dr/2 x UCC0

Depr = 0.15 x 19 000 000
Depr = 2 850 000

Depreciation Expense in Second Year of Operations

45. Tinney & Smyth Inc. is considering the purchase of a new batch polymer-bonding machine
for producing Crazy Rubber, a new children’s toy. The machine will increase EBITDA by
$215,000 per year for the next two years. The machine’s purchase price is $440,000 and the
salvage value at the end of two years is $46,800. The machine is in Class 43 with a 30%
depreciation rate. What is the depreciation expense in the second year of operations? Round your
answer to the nearest dollar.

Depr2 = dr x UCC1 = dr x (1 - dr/2) x UCC0

Depr = 0.3 x (1 – 0.15) x 440 000
Depr = 112 200

How much tax is owed if it is a regular year of operations?

46. Mike Mulligan Excavation Inc. has one Caterpillar 345DL Hydraulic Excavator. It was
purchased at the beginning of 20X4 for $400,000. The excavator is in class 8 with a 20%
depreciation rate. Selected financial values for 20X5 are shown in the table. Assume a corporate
tax rate of 35%. How much tax is owed in 20X5 if it is a regular year of operations? Assume that
the interest expense is zero. Round to the nearest dollar.

Depr = dr x (1 - dr/2) x UCC0

Depr = 0.2 x (1-0.1) x 400 000
Depr = 72 000

Taxes = [EBITDA – Depr] x T

Taxes = ((3 000 000 – 1 350 000 – 990 000) – 72 000)) x 0.35
Taxes = 205 800

UCC at the end of the second year

47. Endo Mountain Bikes Inc. is purchasing a new machine for constructing hydraulic shocks.
The machine costs $3,500,000 and falls into Class 43 with a 30% depreciation rate. What is the
undepreciated capital cost (UCC) at the end of the second year? Round to the nearest dollar.

UCC2 = (1-dr) x UCC1

UCC2 = (1-dr) x (1-dr/2) x UCC0
UCC2= (1 – 0.3) x (1 – 0.15) x 3 500 000
UCC2 = 2 082 500

Depreciation Tax Shield in second year of operations

48. Crazy Rubber, a new children’s toy. The machine will increase EBITDA by $215,000 per year for the
next two years. The machine’s purchase price is $360,000 and the salvage value at the end of two years
is $46,800. The machine is classified as Class 8 with a depreciation rate of 20%. What is the depreciation
tax shield in the second year of operations? Use a tax rate of 35%. Round to the nearest dollar.
Depr2 = dr x (1-dr/2) x UCC0
Depr2 = 0.2 x (1 – 0.1) x 360 000
Depr2 = 64 800

Tax Shield = T x Depr

Tax Shield = 0.35 x 64 800
Tax Shield = 22680

Present Value of Tax Shields

49. Bill Sharpe, owner of Sharper Knives Inc., is closing his business at the end of the current fiscal year.
His sole asset, the knife-sharpening machine, is four years old. The undepreciated capital cost of the
machine is $72,000. The machine is in class 8 with a 20% depreciation rate. Bill has agreed to sell the
machine at the end of the year for $76,143. What is the present value of tax shields associated with the
sale of the machine? The tax rate is 35% and Bill’s cost of capital is 9%.

Present Value of Tax Shields (as of the Terminal Year)

50. Mike Mulligan Excavation Inc. has one Caterpillar 345DL Hydraulic Excavator. It was purchased at the
beginning of 20X4 for $352,141. The excavator is in Class 43 with a 30% depreciation rate. Assume that
the corporate tax rate is 35% and that Mike’s cost of capital is 10%. What is the present value of tax
shields (as of the terminal year) if Mike sells the 345DL at the end of 20X5 for $188,571?
UCC2 = (1-dr) x (1-dr/2) x UCC0
UCC2 = (1 – 0.3) x (1- 0.15) x 352 141
UCC2 = 209 523.895
↓

Reduction in NPV associated with inclusion of missing machinery

52. Bob Cratchit, a new analyst at Scrooge & Marley Inc., has prepared a capital budget for the Tiny Tim
project. He is scheduled to present his analysis at a board meeting in one hour. Bob just received an
email from his boss, Fred Fezziwig, indicating that the capital budget is missing a critical piece of
machinery with a capital cost of $150,000. The machine would be purchased at the outset of the project
(Year 0). The machinery is in Class 8 with a depreciation rate of 20%. The machine will be sold for
$100,000 at the end of the two-year project. The tax rate is 35% and the weighted average cost of capital
is 9%. No other element of the capital budget would be affected. Assume that all cash flows occur at
year-end (except for the purchase of equipment). What is the reduction in NPV associated with the
inclusion of the missing machinery? Round your answer to the nearest dollar

OCF in Year 1 (include depreciation tax shield)

53. Tinney & Smyth Inc. is considering the purchase of a new batch polymer-bonding machine for
producing Crazy Rubber, a new children’s toy. The machine will increase EBITDA by $202,077 per year for
the next two years. The machine’s purchase price is $260,000 and the salvage value at the end of two
years is $46,800. The machine is in Class 43 with a depreciation rate of 30%. The depreciation expense in
Year 1 is $39,000. The tax rate is 35%. What are the operating cash flows for the project in Year 1?
(Include the depreciation tax shield.)
OCF1 = EBITDA x (1-T) + T x Depr1
OCF1 = 202 077 x (1- 0.35) + 0.35 x 39 000
OCF1 = 145 000

OCF in Year 2
56. Ken Smith wants to start a deck and fence company. To start the business, Ken plans to invest
$80,000 in a pick-up truck and tools. The truck and tools are in Class 43 with a depreciation rate of 30%.
Ken is forecasting that he will build 90 decks in the first year and 110 decks in years 2 and 3. He
anticipates that the average deck will be priced at $5,500. Ken estimates that the cost of lumber for the
typical deck is $2,000. Ken estimates that rent, office expenses, vehicle expenses, wages, and salaries will
total $351,400 per year. The corporate tax rate is 30%. What are operating cash flows in the second year
of the business? Round your answer to the nearest dollar.
Depr2 = dr x (1-dr/2) x UCC0
Depr2 = 0.3 x (1- 0.15) x 80 000
Depr2 = 20 400

EBITDA = Revenues – Costs – Expenses

EBITDA = (110 x 5500) – (110 x 2000) – 351 400
EBITDA = 33 600

OCF2 = EBITDA x (1-T) + T x Depr1

OCF2 = 33 600 x (1- 0.3) + 0.3 x 20 400
OCF2 = 29 640
Year Cash Flows
58. Tinney & Smyth Inc. is considering the purchase of a new batch polymer-bonding machine for
producing Crazy Rubber, a children’s toy. The machine will increase EBITDA by $214,940 per year for the
next two years. The machine’s purchase price is $260,000 and the salvage value at the end of two years
is $70,000. The machine is in Class 43 with a 30% depreciation rate. To run the Crazy Rubber production
line, the company will need to purchase an inventory of polydimethylsiloxane and boric acid for a total
cost of $15,000. The operating cash flows in Year 2 are $178,418 and the present value of tax shields is
$16,582. The tax rate is 25% and T&S’s cost of capital is 11%. What are the terminal year cash flows for
the project in Year 2 (including the operating cash flows)?
FCFT = OCF + Decrease in NWC (inventory) + Salvage + PVTS
FCFT = 178 418 + 15 000 + 70 000 + 16 582

Terminal Year Cash Flows (2 years)

60. An increasingly popular trend in mountain biking is to remove the chain and coast down the
mountain. This has reduced demand for crank sets, chains, and derailleurs. As a result, Endo Mountain
Bikes Inc. is shutting down its bicycle propulsion plant. It purchased the plant 2 years ago for $300,000. It
can sell the plant today for $153,938.2. The plant is in Class 43 with a depreciation rate of 30%. When
the plant is closed, Endo’s net working capital will decrease by $50,000. EBITDA in the final year is
$250,000. Endo’s tax rate is 35%, and their cost of capital is 8%. What are the terminal year cash flows?
Round your answer to the nearest dollar.
FCF2 = OCF2 + dec in NWC + Salvage + PVTS
↓

OCF2 = EBITDA x (1-T) + T x Depr1 Depr1 = dr x (1 – dr/2) x UCC0

OCF2 = 250 000 x (1- 0.35) + 0.35 x 76 500 Depr1 = 0.3 x (1 – 0.15) x 300 000
OCF2 = 189 275 Depr 1 = 76 500

UCC2 = (1-dr) x (1-dr/2) x UCC0

PVTS = 6786.8 UCC2 = (1- 0.3) x (1 – 0.15) x 300 000
UCC2 = 178 500

FCF2 = OCF2 + dec in NWC + Salvage + PVTS

FCF2 = 189 275 + 50 000 + 153 938.2 + 6786.8
FCF2 = 400 000
Free Cash Flow in Terminal Year (3-year replacement)
73. POM Bakery is considering replacement of a custard injecting machine with a new high-speed
injector, which can fill twice as many cakes per hour as the old machine. The existing injection machine
was purchased 2 years ago for $4M. It could be sold today for $2M and its expected salvage value in
three years is $0.5M. The injectors are in Class 43 with a 30% depreciation rate. The new custard injector
costs $4M. The new machine will be sold for $1.5M at the end of 3 years. The new machine will increase
EBITDA by $700,000 per year. The company’s tax rate is 40% and its cost of capital is 12%. What is the
free cash flow in the terminal year (three years after replacement)? (Round your answer to the nearest
dollar.)
FCFT = OCF3 + SalvageNew – SalvageOld + PVTS
↓

OCF3 = EBITDA x (1-T) + T x Depr3 Depr3 = dr x (1-dr) x (1 – dr/2) x △C0

OCF3 = 700 000 x (1- 0.4) + 0.4 x 357 000 Depr3 = 0.3x(1- 0.3) x (1 – 0.15)x(4M-2M)
OCF3 = 562 800 Depr3 = 357 000

UCC3 = (1-dr) x (1-dr) x(1-dr/2) x △C0

UCC3 = (1- 0.3) x (1 –0.3) x (1 – 0.15) x (4M – 2M)
UCC3 = 833 000

S = SalvageNew – SalvageOld
S = 1.5M = 0.5M = 1M
PVTS = - 47 714.28571

FCFT = OCF3 + SalvageNew – SalvageOld + PVTS

FCFT 562 800 + 1 500 000 – 500 000 + (-47 714.28571)
FCFT = 1 515 085.714
= 1 515 086

Terminal Cash Flows (4 years, ignoring OCF and depreciation tax shield)
59. Mike Mulligan is winding up his excavation business and retiring. He is selling his steam
shovel, which he affectionately calls Mary Anne, for $177,622.4. He bought Mary Anne new for
$300,000 four years ago (Class 8 with a 20% depreciation rate) and her undepreciated capital
cost is $138,240 today. When Mike sells Mary Anne, he will also sell his spare-parts inventory
for $10,000. Mike’s business is in a 30% tax bracket and his cost of capital is 11%. What are the
terminal year cash flows for Mike Mulligan (ignoring operating cash flows and the depreciation
tax shield)?
FCFT = OCF4 + DecNWC + S + PVTS
Let OCF4 = 0

PVTS = - 7622.4
FCFT = 10 000 + 177 622.4 – 7622.4
FCFT = 180 000

Terminal Year Cash Flows (selling equipment, ignoring OCF and Depr Tax Shield)
Chapter 11 Cost of Capital
After Tax Cost of Preferred Equity
17. What is the after-tax cost of the following preferred equity? The par value of the preferred share is
$100 and the annual dividend is 6%. The preferred shares have no stated maturity. The current market
price of the share is $70. Assume that the corporate tax rate is 30%.

D = Par x Annual Dividend %

D = 100 x 0.06
D = $6

kp= 6 / 70
kp= 8.57%

Cost of the perpetual preferred stock

20. MCG Company decided to sell perpetual (never matures) preferred stock with an 8%
yield (pays out 8% of par as dividend). If the stock had a par value of $150, and the
stated flotation costs would amount to 2% of the par value (flotation cost being the
amount it costs to actually sell the security—the price received by the firm is net of
sales price minus flotation cost), what is the cost of the perpetual preferred stock?

1 2

3 4
Cost of Common Equity
kF = risk-free rate
kM = expected return
B = beta
ke = cost of equity
(kM- kF ) = market risk premium (SOMETIMES THIS IS GIVEN IN QUESTION)

Cost of Common Equity (given dividend and growth rate)

25. Fred's Lawn and Garden's last dividend per share was $2.76. The stock sells for $19 per
share, and the expected growth rate for the company is 8%. Calculate the company's cost of
equity.

D1 = D0 x (1+g) Ke = (2.9808 / 19) + 0.08

D1 = 2.76 x 1.08 Ke = 23.69
D1 = 2.9808

Cost of Common Equity using Constant Growth Dividend Discount Model

30. Pan American Airlines' shares are currently trading at $63.07 each. What is the
estimated cost of common equity, employing the constant growth dividend discount
model? Assume that Pan Am pays annual dividends and that the last dividend of $2.13
per share was paid yesterday. Pan Am started paying dividends 3 years ago. The first
dividend was $1.76 per share.

+ 0.065668 Ke = 10.17%

Cost of Equity using Bond Yield plus a Premium Approach

31. The return on the market is 11.8%. A firm's beta is 1.6 and the risk-free rate is
4.8%. The stock is currently selling for $20.16, and the next dividend is expected to be
$2.17. The firm's growth rate is 5.2%. The cost of debt is 12.4%. Assume the equity risk
premium is 3.6%. Estimate the cost of equity using the bond yield plus a premium
approach.

ke = 0.124 + 0.036
kd = pre-tax cost of debt ke = 16%
ke = cost of equity
0 = equity risk premium