Exam 9: The Cost of Capital

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk,and the projects within the divisions may also vary in risk.Therefore,it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the dividend growth method,and the bond-yield-plus-risk-premium method.However,only the CAPM method always provides an accurate and reliable estimate.

If a firm is privately owned,and its stock is not traded in public markets,then we cannot measure its beta for use in the CAPM model,we cannot observe its stock price for use in the dividend growth model,and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

You were recently hired by Garrett Design,Inc.to estimate its cost of common equity.You obtained the following data: D₁ = $1.75;P₀ = $42.50;g_L = 7.00% (constant);and F = 5.00%.What is the cost of equity raised by selling new common stock?

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

To estimate the company's WACC,Marshall Inc.recently hired you as a consultant.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 common stock,and it does not expect to issue any new shares.What is its WACC?

Which of the following statements is CORRECT?

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 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,is not deductible by the issuing firm.

With its current financial policies,Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings,Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Avery Corporation's target capital structure is 35% debt,10% preferred,and 55% common equity.The interest rate on new debt is 6.50%,the yield on the preferred is 6.00%,the cost of common from reinvested earnings is 11.25%,and the tax rate is 40%.The firm will not be issuing any new common stock.What is Avery's WACC?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method,the dividend growth method,and the bond-yield-plus-risk-premium method.Since we cannot be sure that the estimate obtained with any of these methods is correct,it is often appropriate to use all three methods,then consider all three estimates,and end up using a judgmental estimate when calculating the WACC.

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

Which of the following statements is CORRECT?

Trahern Baking Co.common stock sells for $32.50 per share.It expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,and its expected constant dividend growth rate is 6.0%.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?

When estimating the cost of equity by use of the CAPM,three potential problems are (1)whether to use long-term or short-term rates for r_RF, (2)whether or not the historical beta is the beta that investors use when evaluating the stock,and (3)how to measure the market risk premium,RP_M.These problems leave us unsure of the true value of r_s.

For a typical firm,which of the following sequences is CORRECT? All rates are after taxes,and assume that the firm operates at its target capital structure.

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share,and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue,it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

Which of the following statements is CORRECT?

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