Exam 13: The Cost of Capital

Should a firm with high retained earnings have a lower cost of equity?

Assume preferred stock of Ford Motors pays a dividend of $3.00 each year and trades at a price of $20. What is the cost of preferred stock capital for Ford?

Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

Internal financing is more costly than external financing because of issuance costs.

What is the difference between the effective cost of debt and the cost of debt?

Assume preferred stock of Ford Motors pays a dividend of $4 each year and trades at a price of $35. What is the cost of preferred stock capital for Ford?

Verano Inc. has two business divisions-a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 10% and the waste water clean-up business has a cost of equity capital of 8%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

One should use accounting-based book values rather than market values of debt and equity to determine the weights for the different sources of capital.

The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.

Epiphany is an all-equity firm with an estimated market value of $300,000. The firm sells $250,000 of debt and uses the proceeds to purchase outstanding equity. Compute the weight in equity and the weight in debt after the proposed financing and repurchase of equity.

Verano Inc. has two business divisions-a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 11% and the waste water clean-up business has a cost of equity capital of 4%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

Assume Bismuth Electronics has a book value of $6 billion of equity and a face value of $19.7 billion of debt. The market values of equity and debt are $2.5 billion and $18.5 billion. A Wall Street financial analyst determines values of equity and debt as $3 billion and $20 billion. Which of the following values should be used for calculating the firm's WACC?

A firm is considering acquiring a competitor. The firm plans on offering $160 million for the competitor. The firm will need to issue new debt and equity to finance the acquisition. You estimate the issuance costs to be $10 million. The acquisition will generate an incremental free cash flow of $20 million in the first year and this cash flow is expected to grow at an annual rate of 3% forever. If the firm's WACC is 13%, what is the value of this project?

Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be 7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the firm's tax rate is 40%, compute the WACC?

Different divisions with differing lines of business use different costs of capital because their cost of ________ could be different.

A levered firm is one that has ________ outstanding.

Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 10% weight in equity, 20% in preferred stock, and 70% in debt. The cost of equity capital is 16%, the cost of preferred stock is 10%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

Financial managers must determine their firm's overall cost of capital based on all sources of financing.

Among the two models Constant Dividend Growth Model (CDGM)and Capital Asset Pricing Model (CAPM), which is a better method for computation of the cost of equity?