Exam 12: The Cost of Capital

There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost.For example, a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

Marginal Cost of Capital Global Advertising Company The Global Advertising Company had net income after interest but before taxes of $40,000 this year.The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent.The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000.If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt.The last dividend paid by Global was $0.90.Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent.If Global issues new common stock, the flotation cost incurred will be 10 percent.Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. -Refer to Global Advertising Company.There are two break points in Global's MCC schedule, one when retained earnings have been used up, and one when low-cost debt has been used up ($26,667).Therefore, there are three intervals in the MCC schedule.What is the marginal cost of capital in each of these intervals? 1st interval 2nd interval 3rd interval

Retained earnings have no cost since the firm does not have to issue securities to raise retained earnings.

A breakpoint will occur in the MCC schedule whenever the cost of one of the capital components rises.

Because preferred stock dividends are not tax deductible, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis.

Which of the following statements is correct?

MCC Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity.Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent.The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D₀) was $2.00; and the current equilibrium stock price is $21.88.Byron can raise all the debt financing it needs at 14.0 percent.If Byron issues new common stock, a 20 percent flotation cost will be incurred.The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.What is the component cost of the equity raised by selling new common stock?

Cost of External Equity Becker Glass Corporation Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent.The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding.Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends.The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock.The firm's tax rate is 40 percent. -Refer to Becker Glass Corporation.What is the firm's cost of retained earnings?

WACC Rollins Corporation Rollins Corporation is constructing its MCC schedule.Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity.Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000.The firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred.Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent.Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent.The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find r_s.The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent.Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is the firm's cost of retained earnings using the DCF approach?

Interest paid on corporate debt is tax deductible from the investor's point of view leading investors to accept a lower before-tax return on the corporation's debt.

When a firm's stockholders are not well diversified, the firm's true investment risk will not be measured by beta and the CAPM procedure will ____ the correct value of r_s.

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings.The current market price of the firm's stock is P₀ = $28; its last dividend was D₀ = $2.20, and its expected dividend growth rate is 6 percent.Allison can issue new common stock at a 15 percent flotation cost.What will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital?

Which of the following statements is correct?

Cost of External Equity J.Ross and Sons, Inc. J.Ross and Sons Inc.has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity.The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate.The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock.Ross expects to retain $15,000 in earnings over the next year.Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock.The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. -Refer to J.Ross and Sons.What will be the WACC above this break point?

Which of the following statements is most correct?

Marginal Cost of Capital Global Advertising Company The Global Advertising Company had net income after interest but before taxes of $40,000 this year.The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent.The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000.If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt.The last dividend paid by Global was $0.90.Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent.If Global issues new common stock, the flotation cost incurred will be 10 percent.Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. -Refer to Global Advertising Company.What is the cost of common equity raised by selling new stock?

The cost of debt outstanding or the historical cost of debt is the appropriate component cost of debt that should be used in the firm's investments decisions.

A firm going from a lower to a higher tax bracket could increase its use of debt, yet actually wind up with a lower after-tax cost of debt.

Marginal Cost of Capital Global Advertising Company The Global Advertising Company had net income after interest but before taxes of $40,000 this year.The marginal tax rate is 40 percent, and the dividend payout ratio is 30 percent.The company can raise debt at a 12 percent interest rate for any amount of debt less than $8,000.If the firm raises $8,000 or more of debt, a 15 percent interest rate will apply to that new debt.The last dividend paid by Global was $0.90.Global's common stock is selling for $8.59 per share, and its expected growth rate in earnings and dividends is 5 percent.If Global issues new common stock, the flotation cost incurred will be 10 percent.Global plans to finance all capital expenditures with 30 percent debt and 70 percent equity. -Refer to Global Advertising Company.What is Global's cost of retained earnings?

WACC Rollins Corporation Rollins Corporation is constructing its MCC schedule.Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity.Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000.The firm could sell, at par, $100 preferred stock that pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred.Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent.Rollins is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent.The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find r_s.The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent.Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' lowest WACC?