Exam 9: The Cost of Capital

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 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method.However, only the dividend growth method is widely used in practice.

Which of the following statements is CORRECT?

Taylor 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?

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

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new 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 bal ance sheet and some other in formation 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 betais 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 retum of $14.50 \%$ during the past 5 years. The firm's tax rate is $25 \%$ . -Refer to the data for the Collins Group.What is the best estimate of the after-tax cost of debt?