Exam 12: The Cost of Capital

The expected rate of return on a constant growth stock is equal to the ____ plus its ____.

Jackson Company The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. -Refer to Jackson Company.What will be Jackson's cost of new common stock if it issues new stock in the marketplace today?

Interest paid on corporate debt is tax deductible from the investor's point of view leading investors to accept a lower before-tax return on the corporation's debt.

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

Rollins Corporation Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' cost of retained earnings using the bond-yield-plus-risk-premium approach?

S.Claus & Company is planning a zero coupon bond issue.The bond has a par value of $1,000,matures in 2 years,and will be sold at a price of $826.45.The firm's marginal tax rate is 40 percent.What is the annual after-tax cost of debt to the company on this issue?

It is not possible for a firm's use of debt to increase but its after-tax cost of debt to decline.

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.In other words,the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Martin Corporation's common stock is currently selling for $50 per share.The current dividend is $2.00 per share.If dividends are expected to grow at 6 percent per year and if flotation costs are 10 percent,then what is the firm's cost of retained earnings and what is its cost of new common stock?

Firms should use their weighted average cost of capital (WACC)when they are funding their capital projects with a variety of sources.However,when the firm plans on using only debt or only equity to fund a particular project,it should use the after-tax cost of the specific source of capital to evaluate that project.

The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets.

Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18.0 percent.What is the weighted average cost of capital at that point?

Because preferred stock dividends are not tax deductible,the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis.

Publicly placed bonds do not typically involve flotation costs due to the availability of publicly placed funds,but privately placed debt typically does involve flotation costs because of the difficulty involved in raising private funds.

Which of the following statements is correct?

The marginal cost of capital (MCC)is the cost of the last dollar of new capital that the firm raises,and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

Which of the following statements is most correct?

Since 70 percent of preferred dividends received by a corporation is 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_s(1 − T)(0.70)(0.50).

Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.What is the component cost of the equity raised by selling new common stock?

Becker Glass Corporation Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent. The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding. Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends. The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock. The firm's tax rate is 40 percent. -Refer to J.Ross and Sons.What is the firm's cost of newly issued preferred stock?