Exam 9: The Cost of Capital

In computing the weighted average cost of capital, the target weights are either book value or historical value weights based on actual capital structure proportions.

The cost to a firm of each type of capital is dependent upon ________.

The cost of common stock equity refers to the cost of the next dollar of financing necessary to finance a new investment opportunity.

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

The preferred capital structure weights to be used in the weighted average cost of capital are ________.

The Gordon model assumes that the value of a share of stock equals the future value of the current price of share that it is expected to remain constant over an infinite time horizon.

The constant-growth model uses the market price as a reflection of the expected risk-return preference of investors in the market place.

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. -The firm's after-tax cost of debt is ________. (See Table 9.1)

A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6 percent. The estimated cost of common stock equity is ________.

Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for a firm's nondiversifiable risk.

The ________ is the rate of return that a firm must earn on its investments in order to maintain the market value of its stock.

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. -The firm's before-tax cost of debt is ________. (See Table 9.1)

The before-tax cost of debt for a firm, which has a marginal tax rate of 40 percent, is 12 percent. The after-tax cost of debt is ________.

In using the cost of capital, it is important that it reflects the historical cost of raising funds over the long run.

Debt is generally the least expensive source of capital. This is primarily due to ________.

Using the capital asset pricing model, the cost of common stock equity is the return required by investors as compensation for ________.

A firm has common stock with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the firm's common stock equity is ________.

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. -The firm's cost of a new issue of common stock is ________. (See Table 9.1)

Tangshan Mining is considering issuing long-term debt. The debt would have a 30 year maturity and a 12 percent coupon rate and make semiannual coupon payments. In order to sell the issue, the bonds must be underpriced at a discount of 2.5 percent of face value. In addition, the firm would have to pay flotation costs of 2.5 percent of face value. The firm's tax rate is 33 percent. Given this information, the after-tax cost of debt for Tangshan Mining would be ________.

Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.