1 ) (Divisional costs of capital and investment decisions) Saddle River Operating Company(SROC) is aDallas-based independent oil and gas firm. In thepast, thefirm's managers have used a singlefirm-wide cost of capital of 16 percent to evaluate new investments.However, the firm has long recognized that its exploration and production division is significantly more risky than the pipeline and transportation division. Infact, firms comparable toSROC's E&P division have equity betas of about 1.7, whereas distribution companies typically have equity betas of only 1.2 Given the importance of getting the cost of capital estimate as close to correct aspossible, thefirm's chief financial officer has asked you to prepare cost of capital estimates for each of the two divisions. The requisite information needed to accomplish your task is presentedhere:

The cost of debt financing is 7 percent before taxes of 38 percent.However, if theE&P division were to borrow based on its projectsalone, the cost of debt would probably be 8.4 percent, and the pipeline division could borrow at 5.7 percent. You may assume these costs of debt are after any flotation costs the firm might incur.

Therisk-free rate of interest onlong-term U.S. Treasury bonds is currently 5.4 percent, and themarket-risk premium has averaged 5.2 percent over the past several years.

TheE&P division adheres to a target debt ratio of 20 percent, whereas the pipeline division utilizes 40 percent borrowed funds.

The firm has sufficient internally generated funds such that no new stock will have to be sold to raise equity financing.

a. Estimate the divisional costs of capital for theE&P and pipeline divisions.

b. What are the implications of using acompany-wide cost of capital to evaluate new investment proposals in light of the differences in the costs of capital you estimatedpreviously?

a. What is the divisional cost of capital for theE&P division?

_____ % (Round to two decimalplaces.)

What is the divisional cost of capital for the pipelinedivision?

___ % (Round to two decimalplaces.)

b. "The dramatic difference in the two divisional costs of capital underscores the importance of analyzing the capital costs corresponding to divisions of very different risk."

Is the above statement true orfalse?

2) (Cost of preferred stock) Your firm is planning to issue preferred stock. The stock sells for $115; however, if new stock isissued, the company would receive only $101.20 The par value of the stock is $100 , and the dividend rate is 18 percent. What is the cost of capital for the stock to yourfirm?

a) The cost of capital for the preferred stock to your firm is

___ %. (Round to two decimalplaces.)

3) (Individual or component costs of capital) Compute the cost of thefollowing:

a. A bond that has $1,000 par value(face value) and a contract or coupon interest rate of 7 percent. A new issue would have a floatation cost of 8 percent of the $1,115 market value. The bonds mature in 7 years. Thefirm's average tax rate is 30 percent and its marginal tax rate is 35 percent.

b. A new common stock issue that paid a $1.50 dividend last year. The par value of the stock is$15, and earnings per share have grown at a rate of 9 percent per year. This growth rate is expected to continue into the foreseeable future. The company maintains a constantdividend-earnings ratio of 30 percent. The price of this stock is now $27 but 9 percent flotation costs are anticipated.

c. Internal common equity when the current market price of the common stock is $43 The expected dividend this coming year should be $3.30 increasing thereafter at an annual growth rate of 8 percent. Thecorporation's tax rate is 35 percent.

d. A preferred stock paying a dividend of 9 percent on a $120 par value. If a new issue isoffered, flotation costs will be 14 percent of the current price of $168.

e. A bond selling to yield 14 percent after flotationcosts, but before adjusting for the marginal corporate tax rate of 35 percent. In otherwords, 14 percent is the rate that equates the net proceeds from the bond with the present value of the future cash flows(principal andinterest).

a. What is thefirm's after-tax cost of debt on thebond? __% (Round to two decimalplaces.)

b. What is the cost of external commonequity? ______% (Round to two decimalplaces.)

c. What is the cost of internal commonequity? _____% (Round to two decimalplaces.)

d. What is the cost of capital for the preferredstock? _____% (Round to two decimalplaces.)

e. What is theafter-tax cost of debt on thebond? _____% (Round to two decimalplaces.)