Exam 10: The Cost of Capital

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).

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

Since 70% of the preferred dividends received by a corporation are excluded from taxable income,the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should,theoretically,be ? Cost of equity = r_s(0.30)(0.50)+ r_ps(1 - T)(0.70)(0.50).

The 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.

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

A.Butcher Timber Company hired your consulting firm to help them estimate the cost of equity.The yield on the firm's bonds is 6.75%,and your firm's economists believe that the cost of equity 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 equity from retained earnings?

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

Eakins Inc.'s common stock currently sells for $15.00 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 retained earnings? Do not round your intermediate calculations.

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

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

A company's perpetual preferred stock currently sells for $102.50 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?

Exhibit 10.1 Assume that you have been hired as a consultant by CGT,a major producer of chemicals and plastics,including plastic grocery bags,styrofoam cups,and fertilizers,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 \ 80,000,000 Total liabilities and sharehol ders' equity \ 139,000,000 The stock is currently selling for $17.75 per share,and its noncallable $3,319.97 par value,20-year,1.70% bonds with semiannual payments are selling for $881.00.The beta is 1.29,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 40%. -Refer to Exhibit 10.1.Based on the CAPM,what is the firm's cost of equity?

Keys 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 45.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? Do not round your intermediate calculations.

Bosio Inc.'s perpetual preferred stock sells for $85.00 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?

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

O'Brien Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 0.70.What is the firm's cost of equity from retained earnings based on the CAPM?

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25;P₀ = $22.50;g = 5.00% (constant);and F = 6.00%.What is the cost of equity raised by selling new common stock?

Which of the following statements is CORRECT?

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.

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?