Here is one question from becker

1. DQZ Telecom is considering a project for the coming year, which will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.

•    Issue $15million of 20-year bonds at a price of 101, with a coupon rate of 8 percent, and flotation costs of 2 percent of par
• use $35 million of funds generated from earnings

The equity market is expected to earn 12%, U.S. treasury bonds are currently yielding 5%, the beta coefficient for DQZ is estimated to be 0.60. DQZ is subject to an effective corporate income rate of 40%. Assume that the after-tax cost of debt is 7% and the cost of equity is 12%. Determine the WACC.

    The answer from becker is 10.5%. I can understand how they get the answer. but there are two points I am confused. 

    1. they have given the information about calculating the cost of debt and cost of retained earning seperately. Why could not we use them to calculate? In fact, I got different cost of debt and cost of retained earning from them.

    Cost of RE = 5% + 0.6*(12%-5%) = 9.2%

    Cost of Debt = [8% + (100-99)/20]/[(100+99)/2]*(1-0.4)= 4.9%

    What is wrong with these calculation?

   2. for the cost of equity, should it be after-tax cost of equity or just cost of equity. I remember that tax should not be considered. but in another becker question, it asked about WACC and give the information about after-tax cost of debt of 9% and an after-tax cost of equity of 15%, the calculation is the same as the above one. I am so confused about it

  Anyone please help?? Thanks!!!!

1. I agree, but I guess if the problem says assume such-and-such, we are to assume such-and-such.

2. after-tax cost of equity always equals before-tax cost of equity.  It's only for debt that after-tax cost differs from before-tax cost - because interest expense is deductible for tax, but dividend payments are not.

Thanks a lot! Kj_nyc. Now I understand the cost of equity. I am newbie here. Good Luck on your exam!

kj_nyc wrote: Thanks, good luck to you as well.  When is your exam?  Mine is Oct 6, just a week away, yikes!

We are on the same day! Feel nervous now. This is my first exam. not feel comfortable about the IT part now. I am just using the old 2008 backer, not sure whether it is enough....