Exam 9: Cost of Capital

investors' aversion to risk rose, causing the slope of the SML to increase, 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.Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity.However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity.The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using retained earnings is 12.75%.The firm will not be issuing any new stock.What is its WACC?

cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually.The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach, what is the cost of common from retained earnings?

Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock.Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Suppose the debt ratio

Suppose you are the president of a small, publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

Which of the following statements is CORRECT?

Assume that Kish Inc.hired you as a consultant to help estimate its cost of common equity.You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% Based on the DCF approach, what is the cost of common from retained earnings?

higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

Bouchard and Company hired you as a consultant to help estimate its cost of common equity.You have obtained the following data: D0 = $0.85; P0 = $22.00; and g = 6.00% 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 retained earnings change if the stock price changes as the CEO expects?

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

LaPango Inc.estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%.Which of the following projects (A, B, and C) should the company accept?

company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

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

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 DCF method is widely used in practice.

Safeco Company and Risco Inc are identical in size and capital structure.However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%.Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project.Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc.Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?

Rivoli Inc.hired you as a consultant to help estimate its cost of common equity.You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% Based on the DCF approach, what is the cost of common from retained earnings?

Butcher Timber Company hired your consulting firm to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of common from retained earnings?