Exam 9: The Cost of Capital

The average cost of capital is the appropriate rate to use when evaluating new investments,even though the new investments may be in a higher risk class.

Baxter Inc.has a target capital structure of 30% debt,15% preferred stock,and 55% common equity.The company's after-tax cost of debt is 7%,its cost of preferred stock is 11%,its cost of retained earnings is 15%,and its cost of new common stock is 16%.The company stock has a beta of 1.5 and the company's marginal tax rate is 35%.What is the company's weighted average cost of capital if retained earnings are used to fund the common equity portion?

Financing with new common stock is generally more costly than financing with retained earnings due to increasing tax rates.

A firm's cost of capital is the required rate of return on the firm's average project.

Johnson Production Company paid a dividend yesterday of $3.50 per share.The dividend is expected to grow at a constant rate of 10% per year.The price of KayCee's common stock today is $40 per share.If KayCee decides to issue new common stock,flotation costs will equal $4.00 per share.KayCee's marginal tax rate is 35%.Based on the above information,the cost of new common stock is

Mountain Retreat and Resort is undergoing a major expansion.The expansion will be financed by issuing new 15-year,$1,000 par,9% annual coupon bonds.The market price of the bonds is $1,070 each.The firm's flotation expense on the new bonds will be $50 per bond.The firm's marginal tax rate is 35%.What is the relevant cost of the new bonds for capital budgeting purposes?

Two considerations that cause a corporation's cost of capital to be different than its investors' required returns are

Higher flotation costs will result in all of the following EXCEPT

Due to changes in regulatory requirements,the transactions costs associated with selling corporate securities increased by $1 per share.This change will

The firm's cost of capital is important when evaluating the firm's overall value,but it should not be used to evaluate individual projects which have their own unique characteristics.

What practical problems are encountered in using the CAPM to estimate common equity capital cost?

Toombes,Inc.is issuing new common stock at a market price of $55.Dividends last year were $3.30 per share and are expected to grow at a rate of 6%.Flotation costs will be 5% of the market price.What is Toombes' cost of retained earnings,and new equity,respectively?

Coyote Inc.operates three divisions.One division involves significant research and development,and thus has a high-risk cost of capital of 15%.The second division operates in business segments related to Coyote's core business,and this division has a cost of capital of 10% based upon its risk.Coyote's core business is the least risky segment,with a cost of capital of 8%.The firm's overall weighted average cost of capital of 11% has been used to evaluate capital budgeting projects for all three divisions.This approach will

Last year Gator Getters,Inc.had $50 million in total assets.Management desires to increase its plant and equipment during the coming year by $12 million.The company plans to finance 40 percent of the expansion with debt and the remaining 60 percent with equity capital.Bond financing will be at a 9 percent rate and will be sold at its par value.Common stock is currently selling for $50 per share,and flotation costs for new common stock will amount to $5 per share.The expected dividend next year for Gator is $2.50.Furthermore,dividends are expected to grow at a 6 percent rate far into the future.The marginal corporate tax rate is 34 percent.Internal funding available from additions to retained earnings is $4,000,000. a.What amount of new common stock must be sold if the existing capital structure is to be maintained? b.Calculate the weighted marginal cost of capital at an investment level of $12 million.

The cost of common equity financing is more difficult to estimate than the costs of debt and preferred equity.Explain why.

If a firm's tax rate increases,then its weighted average cost of capital increases also.

A company has preferred stock that can be sold for $21 per share.The preferred stock pays an annual dividend of 3.5% based on a par value of $100.Flotation costs associated with the sale of preferred stock equal $1.25 per share.The company's marginal tax rate is 35%.Therefore,the cost of preferred stock is

Dickerson Corporation's common stock is currently selling for $38.Last year's dividend was $4.00 per share.Investors expect dividends to grow at an annual rate of 7 percent indefinitely.Flotation costs of 4% will be incurred when new stock is sold. a.What is the cost of internal common equity? b.What is the cost of new common equity?

Kokapeli,Inc.has a target capital structure of 40% debt and 60% common equity,and has a 40% marginal tax rate.If the firm's yield to maturity on bonds is 7.5% and investors require a 15% return on the firm's common stock,what is the firm's weighted average cost of capital?

Valley Flights,Inc.has a capital structure made up of 40% debt and 60% equity and a tax rate of 30%.A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon of 9% at a price of $1,098.18 with no flotation costs.The firm has no internal equity available for investment at this time,but can issue new common stock at a price of $45.The next expected dividend on the stock is $2.70.The dividend for the firm is expected to grow at a constant annual rate of 5% per year indefinitely.Flotation costs on new equity will be $7.00 per share.The company has the following independent investment projects available: Which of the above projects should the company take on?