Exam 9: Cost of Capital

expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

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.

Bolster Foods' (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%.The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million.The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00.The current stock price is $20.00 per share, and stockholders' required rate of return, rs, is 12.25%.The company recently decided that its target capital structure should have 35% debt, with the balance being common equity.The tax rate is 40%.Calculate WACCs based on book, market, and target capital structures.What is the sum of these three WACCs?

text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method.However, only the CAPM method always provides an accurate and reliable estimate.

capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital--i.e., use these funds first--because retained earnings have no cost to the firm.

Which of the following statements is CORRECT?

Eakins Inc.'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 retained earnings?

a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

Which of the following statements is CORRECT?

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 deductable by the issuing firm.

MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted, what is likely to happen over time?

cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Which of the following statements is CORRECT?

Sorensen Systems Inc.is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $52.50 a share.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 retained earnings?

Which of the following statements is CORRECT?

were recently hired by Scheuer Media Inc.to estimate its cost of common equity.You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%.What is the cost of equity raised by selling new common stock?

is the best estimate of the firm's WACC?

Cranberry Corp.has two divisions of equal size: a computer manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC.He also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently, he estimates that the composite, or corporate, WACC is 10%.A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division.However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions.Which of the following statements is CORRECT?

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.