Exam 10: The Cost of Capital

In general,firms should use their weighted average cost of capital (WACC)to evaluate capital budgeting projects because most projects are funded with general corporate funds,which come from a variety of sources.However,if the firm plans to use only debt or only equity to fund a particular project,it should use the after-tax cost of that specific type of capital to evaluate that project.

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.

Duval Inc.uses only equity capital,and it has two equally-sized divisions.Division A's cost of capital is 10.0%,Division B's cost is 14.0%,and the corporate (composite)WACC is 12.0%.All of Division A's projects are equally risky,as are all of Division B's projects.However,the projects of Division A are less risky than those of Division B.Which of the following projects should the firm accept?

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.

Vang Enterprises,which is debt-free and finances only with equity from retained earnings,is considering 7 equal-sized capital budgeting projects.Its CFO hired you to assist in deciding whether none,some,or all of the projects should be accepted.You have the following information: r_RF = 4.50%;RP_M = 5.50%;and b = 0.98.The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk.Data on the 7 projects are shown below.If these are the only projects under consideration,how large should the capital budget be? Project Risk Risk factor Expected return Cost (millions) 1 Very low -2.00\% 7.60\% \ 25 2 Low -1.00\% 9.15\% \ 25 3 Average 0.00\% 10.10\% \ 25 4 High 1.00\% 10.40\% \ 25 5 Very high 2.00\% 10.80\% \ 25 6 Very high 2.00\% 10.90\% \ 25 7 Very high 2.00\% 13.00\% \ 25 ?

Which of the following statements is CORRECT?

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The balance sheet also shows that the company has 10 million shares of common stock,and the book value of the common equity (common stock plus retained earnings)is $65 million.The current stock price is $22.50 per share;stockholders' required return,r_s,is 14.00%;and the firm's tax rate is 40%.The CFO thinks the WACC should be based on market value weights,but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

Norris Enterprises,an all-equity firm,has a beta of 2.0.The chief financial officer is evaluating a project with an expected return of 14%,before any risk adjustment.The risk-free rate is 5%,and the market risk premium is 4%.The project being evaluated is riskier than the firm's average project,in terms of both its beta risk and its total risk.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.

Which of the following statements is CORRECT?

Teall Development Company hired you as a consultant to help them estimate its cost of capital.You have been provided with the following data: D₁ = $1.45;P₀ = $19.00;and g = 6.50% (constant).Based on the DCF approach,what is the cost of equity from retained earnings?

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.What is the best estimate of the firm's WACC? Do not round your intermediate calculations.

S.Bouchard and Company hired you as a consultant to help estimate its cost of capital.You have obtained the following data: D₀ = $0.85;P₀ = $22.00;and g = 6.00% (constant).The CEO thinks,however,that the stock price is temporarily depressed,and that it will soon rise to $34.00.Based on the DCF approach,by how much would the cost of equity from retained earnings change if the stock price changes as the CEO expects? Do not round your intermediate calculations.

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.

Sorensen Systems Inc.is expected to pay a $2.50 dividend at year end (D₁ = $2.50),the dividend is expected to grow at a constant rate of 5.50% a year,and the common stock currently sells for $37.50 a share.The before-tax cost of debt is 7.50%,and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from retained earnings? Do not round your intermediate calculations.

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC)for use in capital budgeting?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method,we can generally get a good idea of the interest rate on new long-term debt,but we cannot be sure that the risk premium we add is appropriate.This problem leaves us unsure of the true value of r_s.

Which of the following statements is CORRECT?

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.

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