Exam 10: The Cost of Capital

For capital budgeting and cost of capital purposes,the firm should always consider retained earnings as the first source of capital (i.e.,use these funds first)because retained earnings have no cost to the firm.

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital.You have obtained the following data: (1)r_d = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%.(2)r_RF = 5.00%,RP_M = 6.00%,and b = 1.25.(3)D₁ = $1.20,P₀ = $35.00,and g = 8.00% (constant).You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates.What is that difference?

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

"Capital" is sometimes defined as funds supplied to a firm by investors.

Which of the following statements is CORRECT?

LaPango Inc.estimates that its average-risk projects have a WACC of 10%,its below-average risk projects have a WACC of 8%,and its above-average risk projects have a WACC of 12%.Which of the following projects (A,B,and C)should the company accept?

Daves Inc.recently hired you as a consultant to estimate the company's WACC.You have obtained the following information.(1)The firm's noncallable bonds mature in 20 years,have an 8.00% annual coupon,a par value of $1,000,and a market price of $1,050.00.(2)The company's tax rate is 40%.(3)The risk-free rate is 4.50%,the market risk premium is 5.50%,and the stock's beta is 1.20.(4)The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of equity,and it does not expect to issue any new common stock.What is its WACC?

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.

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,are not deductible by the issuing firm.

Rivoli Inc.hired you as a consultant to help estimate its cost of capital.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g = 8.00% (constant).Based on the DCF approach,what is the cost of equity from retained earnings?

To help finance a major expansion,Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity.This bond has a 9.25% annual coupon,paid semiannually,sells at a price of $1,075,and has a par value of $1,000.If the firm's tax rate is 40%,what is the component cost of debt for use in the WACC calculation?

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. ​ The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, 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 after-tax cost of debt?

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 30.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

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.

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.

When estimating the cost of equity by use of the DCF method,the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of r_s.

Bolster Foods' (BF)balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%.The yield to maturity on this debt is 8.00%,and the debt has a total current market value of $27 million.The balance sheet also shows that the company has 10 million shares of stock,and the stock has a book value per share of $5.00.The current stock price is $20.00 per share,and stockholders' required rate of return,r_s,is 12.25%.The company recently decided that its target capital structure should have 35% debt,with the balance being common equity.The tax rate is 40%.Calculate WACCs based on book,market,and target capital structures,and then find the sum of these three WACCs.

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.

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 $40.00.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?