Exam 9: The Cost of Capital

Bloom and Co.has no debt or preferred stock- it uses only equity capital,and has two equally-sized divisions.Division X's cost of capital is 10.0%,Division Y's cost is 14.0%,and the corporate (composite)WACC is 12.0%.All of Division X's projects are equally risky,as are all of Division Y's projects.However,the projects of Division X are less risky than those of Division Y.Which of the following projects should the firm accept?

Suppose the debt ratio (D/TA)is 50%,the interest rate on new debt is 8%,the current cost of equity is 16%,and the tax rate is 40%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

Which of the following statements is CORRECT?

Since 70% of the preferred dividends received by a corporation are excluded from taxable income,the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,theoretically,be Cost of equity = r_s(0.30) (0.50)+ r_ps(1 - T) (0.70) (0.50).

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm F's earnings and stock price move counter cyclically with J and other S&P companies.Both J and F estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,is not deductible by the issuing firm.

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of r_s.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

To estimate the company's WACC,Marshall Inc.recently hired you as a consultant.You have obtained the following information.(1)The firm's noncallable bonds mature in 20 years,have an 8.00% annual coupon,a par value of $1,000,and a market price of $1,050.00.(2)The company's tax rate is 40%.(3)The risk-free rate is 4.50%,the market risk premium is 5.50%,and the stock's beta is 1.20.(4)The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of common stock,and it does not expect to issue any new shares.What is its WACC?

If a firm's marginal tax rate is increased,this would,other things held constant,lower the cost of debt used to calculate its WACC.

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D₁ = $2.50),and the dividend is expected to grow at a constant rate of 5.50% a year.The before-tax cost of debt is 7.50%,and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from reinvested earnings?

Which of the following statements is CORRECT?

Exhibit 9.1 The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -Refer to Exhibit 9.1.Based on the CAPM,what is the firm's cost of common stock?

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D₀ = $0.85; P₀ = $22.00; and g = 6.00% (constant).The CEO thinks,however,that the stock price is temporarily depressed,and that it will soon rise to $40.00.Based on the DCF approach,by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 9%,while stand-alone furniture manufacturers typically have a 13% WACC.She also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently,she estimates that the composite,or corporate,WACC is 11%.A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division.However,the CFO disagrees,and she has assigned an 11% WACC to all projects in both divisions.Which of the following statements is CORRECT?

The Lincoln Company sold a $1,000 par value,noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $925 and the company's tax rate is 40%.What is the component cost of debt for use in the WACC calculation?

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Weatherall Enterprises has no debt or preferred stock - it is an all-equity firm?and has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%,before any risk adjustment.The risk-free rate is 5%,and the market risk premium is 4%.The project being evaluated is riskier than an average project,in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

As the winner of a contest,you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire's common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of common from reinvested earnings?