Exam 9: The Cost of Capital

CrochetCo is considering an investment in a project which would require an initial outlay of $350,000 and produce expected cash flows in years 1-5 of $95,450 per year.You have determined that the current after-tax cost of the firm's capital (required rate of return)for each source of financing is as follows: Long-term debt currently makes up 25% of the capital structure,preferred stock 15%,and common stock 60%.What is the net present value of this project?

The cost of debt measures the cost of a bank loan,while the cost of preferred stock is used as a proxy for the cost of a new bond issue.

Meacham Corp.wants to issue bonds with a 9% coupon rate,a face value of $1,000,and 12 years to maturity.Meacham estimates that the bonds will sell for $1,090 and that flotation costs will equal $15 per bond.Meacham Corp.common stock currently sells for $30 per share.Meacham can sell additional shares by incurring flotation costs of $3 per share.Meacham paid a dividend yesterday of $4.00 per share and expects the dividend to grow at a constant rate of 5% per year.Meacham also expects to have $12 million of retained earnings available for use in capital budgeting projects during the coming year.Meacham's capital structure is 40% debt and 60% common equity.Meacham's marginal tax rate is 35%. a.Calculate the after-tax cost of debt assuming Meacham's bonds are its only debt. b.Calculate the cost of retained earnings. c.Calculate the cost of new common stock. d.Calculate the weighted average cost of capital assuming Meacham's total capital budget is $30 million.

Keystone Corporation will issue new common stock to finance an expansion.The existing common stock just paid a $1.50 dividend,and dividends are expected to grow at a constant rate 8% indefinitely.The stock sells for $45,and flotation expenses of 5% of the selling price will be incurred on new shares.What is the cost of new common stock be for Keystone Corp.?

When a privately owned company decides to distribute its shares to the general public,it goes through a process known as an initial public offering (IPO).List and describe at least three advantages and three disadvantages to having a firm's shares traded in the public equity market.

Texas Transport has five possible investment projects for the coming year.Each project is indivisible.They are: The firm's weighted marginal cost of capital schedule is 12 percent for up to $6 million of investment; 16 percent for between $6 million and $18 million of investment; and above $18 million the weighted cost of capital is 18 percent.The optimal capital budget is

The cost of retained earnings is less than the cost of new common stock because

The preferred stock of Wells Co.sells for $17 and pays a $1.75 dividend.The net price of the stock after issuance costs is $15.30.What is the cost of capital for new preferred stock?

The cost of debt capital is obtained by substituting the net proceeds per bond for the bond price in the bond valuation equation and solving for the required return.

Which of the following should NOT be considered when calculating a firm's WACC?

Why should firms that own and operate multiple businesses that have different risk characteristics use business-specific,or divisional costs of capital?

An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt,but have no impact on its cost of preferred stock or cost of common equity.

Crandal Dockworks 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.Crandal's flotation expense on the new bonds will be $50 per bond.Crandal's marginal tax rate is 35%.What is the pre-tax cost of debt for the newly-issued bonds?

If a firm has decided to move from a situation in which it uses a company-wide cost of capital to divisional costs of capital,what problems is it likely to encounter?

The after-tax cost of equity equals one minus the marginal tax rate times the required rate of return on common stock.

A firm's weighted average cost of capital is a function of (1)the individual costs of capital,(2)the capital structure mix,and (3)the level of financing necessary to make the investment.

What are the implications for a firm's capital investment decisions of using a company-wide cost of capital when the firm has multiple operating divisions that have unique risk attributes and capital costs?

If a firm were to earn exactly its cost of capital,we would expect the price of its common stock to remain unchanged.

Jiffy Co.expects to pay a dividend of $3.00 per share in one year.The current price of Jiffy common stock is $60 per share.Flotation costs are $3.00 per share when Jiffy issues new stock.What is the cost of internal common equity (retained earnings)if the long-term growth in dividends is projected to be 8 percent indefinitely?

The risk-free rate of return is 2.5% and the market risk premium is 8%.Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%.Rogue Transport's marginal tax rate is 35%.Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future.Using the capital asset pricing model,what is Rogue Transport's cost of retained earnings?