Exam 9: The Cost of Capital

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for r_RF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RP_M.These problems leave us unsure of the true value of r_s.

The cost of debt, r_d, is normally less than r_s, so r_d(1 − T) will normally be much less than r_s.Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than r_d(1 − T).

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

When working with the CAPM, which of the following factors can be determined with the most precision?

When estimating the cost of equity by use of the dividend growth method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

The Anderson 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?

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

"Capital" is sometimes defined as funds supplied to a firm by investors.

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

Which of the following statements is CORRECT?

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, r_s, than on the interest rate on long-term debt, r_d, 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.

Collins Group 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. Assets Current assets \ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets \ 139,000,000 Liabilities and Equity Accounts payable \ 10,000,000 Accruals 9,000,000 Current liabilities \ 19,000,000 Long-term debt ( 40,000 bonds, \ 1,000 par value) 40,000,000 Total liabilities \ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity \ 0,000,000 Total liabilities and shareholders' equity \ 139,000,000 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 25%. -Refer to the data for the Collins Group.Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

Which of the following statements is CORRECT?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g_L = 5.00% (constant); and F = 6.00%.What is the cost of equity raised by selling new common stock?

A 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?

Collins Group 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. Assets Current assets \ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets \ 139,000,000 Liabilities and Equity Accounts payable \ 10,000,000 Accruals 9,000,000 Current liabilities \ 19,000,000 Long-term debt ( 40,000 bonds, \ 1,000 par value) 40,000,000 Total liabilities \ 59,000,000 Common stock (10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity \ 0,000,000 Total liabilities and shareholders' equity \ 139,000,000 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 25%. -The 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 reinvested earnings, whose cost is the average return on the assets that are acquired.

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.