Exam 9: The Cost of Capital

As the winner of a contest,you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire's common stock currently sells for $45.00 per share,the company expects to earn $2.75 per share during the current year,its expected payout ratio is 70%,and its expected constant growth rate is 6.00%.New stock can be sold to the public at the current price,but a flotation cost of 8% would be incurred.By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm F's earnings and stock price move counter cyclically with J and other S&P companies.Both J and F estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?

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

Which of the following statements is CORRECT?

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D₀ = $0.85;P₀ = $22.00;and g_L = 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 dividend growth model,by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

Which of the following statements is CORRECT?

Westbrook's Painting Co.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?

As the assistant to the CFO of Johnstone Inc. ,you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80;P₀ = $22.50;and g_L = 8.00% (constant).Based on the dividend growth model,what is the cost of common from reinvested earnings?

Which of the following statements is CORRECT?

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and reinvested earnings,whose cost is the average return on the assets that are acquired.

When estimating the cost of equity by use of the dividend growth 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.

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Adams Inc.has the following data: r_RF = 5.00%;RP_M = 6.00%;and b = 1.05.What is the firm's cost of common from reinvested earnings based on the CAPM?

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and 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 an average project,in terms of both its beta risk and its total risk.Which of the following statements is CORRECT?

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%;RP_M = 5.25%;and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

Assume that you are an intern with the Brayton Company,and you have collected the following data: The yield on the company's outstanding bonds is 7.75%;its tax rate is 40%;the next expected dividend is $0.65 a share;the dividend is expected to grow at a constant rate of 6.00% a year;the price of the stock is $15.00 per share;the flotation cost for selling new shares is F = 10%;and the target capital structure is 45% debt and 55% common equity.What is the firm's WACC,assuming it must issue new stock to finance its capital budget?

The cost of external equity capital raised by issuing new common stock (r_e)is defined as follows,in words: "The cost of external equity equals the cost of equity capital from retaining earnings (r_s),divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

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.

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely