Tutorial Questions - Cost of Capital
1. In the calculation of the WACC for a DCF (in a classical-tax system) why do we multiply the cost of debt by the marginal tax rate?
2. The following are the betas of the equity of four companies in the same industry and their debt/equity ratios.
Company

Beta

Debt/Equity Ratio

AFL

1.15

33.91%

VFL

1.18

54.14%

NRL

1.05

45.50%

ARU

0.91

11.29%

The corporate tax rate is 40%.
A. Estimate the un-levered beta of each firm. What do the unlevered betas tell you about these firms?
B. Assume that ARU is planning to increase its debt/equity ratio to 30%. What will its new beta be?
3. Kleenex has 1.13 billion shares traded at a market value of $32 per share, and 1.918 billion in book value of outstanding debt (with an estimated market value of $2bn).
The equity has a book value of $5.5 billion, and the stock has a beta of 1.10. The firm paid interest expenses of $160m in the most recent financial year, is rated AAA and paid 35% of its income as taxes. The thirty-year government bond rate is 6.25%, and
AAA bonds trade at a spread of twenty basis points over the Treasury bond rate.
Assume a market risk premium of 6%.
A. What are the market value and book value weights on debt and equity?
B. What is the cost of equity?
C. What is the after-tax cost of debt?
D. What is the cost of capital?

4. Loffler Studios has 710 million shares trading at $55 per share and $69 billion in debt outstanding (with a market value of $65 billion), on which it incurred an interest expense of $5 billion in the most recent year. It also has $4 billion in preferred stock outstanding on which it paid a dividend of $365 million. The stock has a beta of 1.10 and is rated A (which commands a spread of 1.25% over the Treasury bond rate of
6.25%). The company faces a corporate tax rate of 40%. Assume a