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Corporate Finance Question

From required readings reading 32 problem 10.

Cost of Capital 10%
50% debt, 50% equity
Before tax cost of debt = 5%
Tax = 20%

The cost of equity is

A 10%
B 12 %
C 14%
D 16%

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D

After tax cost of debt = 5 X (1 - 0.2) = 4%

Cost of Capital = (0.5 X 4) + (0.5 X [cost of equity]) = 10%

Solve for [cost of equity] and you get [cost of equity] = 16%. Hence, D

You should post it in the Level 1 forum.

Olivier Wagner

This is out of the L2 CFAI Corp Finance book… CFAI has C listed as the correct answer (incorrectly).

From Appendix A:

Re= .1 + (.1-.05)(1)(1-.2)
Re= .1 +(.05)(.9) = .14 = C

The correct answer, however, is D, as (1 - .2)(1) = .8 and not .9

Actually, if you guys can all weigh in on this that would be useful, because I got D in my head and that’s the way I usually solve these problems. HOWEVER, the CFAI books all propose the formula used in that answer and in the book they consistantly use it the whole way through that section. It was disturbing to me because solving the way we did (making it an easy L1 question), I got every one of those wrong in the book practice Q’s. It left me startled because if they stick to this on the test, if you solve it intuitively like we all just did, we’d be wrong even though our method makes sense fundamentally. So if anyone could offer their opinions that would be helpful.

#FreeCVM #FreeTurd #2007-2017

.

Yeah that formula is weird. I haven’t checked the errata but C is given as the correct answer in the book.

This is D for sure.

For the same reasons posted above. This is an easy question which it looks like the CFAI made a mistake in calculating.

But they use that formula repeatedly in the CFAI text for L2 corp finance and state that that is the crazy formula is the correct one. It’s not a one time formula, it really has me concerned. I’m with you guys, but they state it pretty clearly. I’ve been at starbucks all day and don’t have the corp fin book with me or i’d put the quoted text, I’ll look for it tomorrow and see if I can post it.

#FreeCVM #FreeTurd #2007-2017

i had the same challenge i just checked in my text and I have made a note that the errata has corrected it.

the correct answer is D. 16%

Here is the equation given (page 120, reading 32).

r(a) = WACC
r(d) = Cost of Debt
r(e) = Cost of Equity
D = Value of Debt
E = Value of Equity
V = Value of D+E

r(e) = r(a) + (r(a) - r(d))*(D/E) <— this is just the normal WACC formula rearranged

For the numbers they gave us

r(a) = 10%
r(d) = 5% *(1-t) = 5%*(.8) = 4%
r(e) = UNKNOWN
D = 50 (i just picked a number)
E = 50 (same as D since the firm is 50% D and 50% E)
V = D+E = 50+50=100

r(e) = 10% + (10% - 4%)*(50/50)
r(e) = 10% + (6%)*(1)
r(e) = 10% + (6%)
r(e) = 16%

Our thought process is correct, CFAI messed up the calculations.

Here was their answer:

r(e) = 10% + (10% - 5%)*(50/50)*(1-tax)
r(e) = 10% + (5%)*(1)*(1-.2)
r(e) = 10% + 5%*(.90) <——- JUST AS McLeod81 POINTED OUT, (1 - .2) = .8, NOT .9.
r(e) = 10% + 4.5%
r(e) = 14.5%

I’m going to send a statement of errata via registered mail 2 days after the exam to CFAI with the message “Now we’re even.”

#FreeCVM #FreeTurd #2007-2017

50%*X + 50%*5%(1-0.2)=10%

50%X=8%
X=16%
D

haven’t got there yet but the formula you are presenting is strange

grace grace Wrote:
——————————————————-
> i had the same challenge i just checked in my text
> and I have made a note that the errata has
> corrected it.
>
> the correct answer is D. 16%

Grace is right - the Errata has already recorded this error. I recommend checking for updates frequently although I wish the CFAI would send out emails every time it changes.

Sorry for joining the rave late, but the answer for this has to be D, else I call it quits!!

if i see a question like this on the exam…..expect to see me jumping up on my table and screaming for joy!!!