Exam 10: Determining the Cost of Capital

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. Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

Grateway Inc. has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55 percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity portion of its capital budget. The before-tax cost of debt is 9 percent, and the company's tax rate is 30 percent. If the expected dividend next period (D1) and current stock price are $5 and $45, respectively, what is the company's growth rate?

What is Rollins' WACC?

The cost of equity capital from the sale of new common stock (re) is generally equal to the cost of equity capital from retention of earnings (rs), divided by one minus the flotation cost as a percentage of sales price (1 - F).

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost.

Which of the following statements is most correct?

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

Which of the following statements is most correct?

It is not possible for a firm's use of debt to increase but its after-tax cost of debt to decline.

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent. -What is Rollins' component cost of debt?

The Global Advertising Company has a marginal tax rate of 40 percent. The last dividend paid by Global was $0.90. Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent. What is Global's cost of common stock?

Suppose the debt ratio (D/TA) is 10 percent, the current cost of debt is 8 percent, the current cost of equity is 16 percent, and the tax rate is 40 percent. An increase in the debt ratio to 20 percent would decrease the weighted average cost of capital.

If 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. In other words, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent. -What is Rollins' cost of preferred stock?

In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm.

A company's balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current market value of $25 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The current return required by stockholders, rS, is 12 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital should you use to evaluate potential projects?

The cost of common stock is the rate of return stockholders require on the firm's common stock.

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

Which of the following statements is most correct?

Which of the following statements is most correct?