Exam 12: The Cost of Capital

In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, because this is a free source of funding to the firm.

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

S.Claus & Company is planning a zero coupon bond issue.The bond has a par value of $1,000, matures in 2 years, and will be sold at a price of $826.45.The firm's marginal tax rate is 40 percent.What is the annual after-tax cost of debt to the company on this issue?

Tapley Inc.'s current (target) capital structure has a target debt-to-assets ratio (D/TA) of 60 percent.The firm can raise up to $5 million in new debt at a before-tax cost of 8 percent.If more debt is required, the initial cost will be 8.5 percent, and if more than $10 million of debt is required, the cost will be 9 percent.Net income for the previous year was $10 million, and it is expected to increase by 10 percent this year.The firm expects to maintain its dividend payout ratio of 40 percent on the 1 million shares of common stock outstanding.If it must sell new common stock, it would encounter a 10 percent flotation cost on the first $2 million, a 15 percent cost if more than $2 million but less than $4 million is needed, and a 20 percent cost if more than $4 million of new outside equity is required.Tapley's tax rate is 30 percent, and its current stock price is $88 per share.If the firm has an unlimited number of projects that will earn a 10.25 percent return, what is the maximum capital budget that can be adopted without adversely affecting stockholder wealth?

Your company's stock sells for $50 per share, its last dividend (D₀) was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000, the firm's payout ratio is 60 percent, and its common equity ratio is 30 percent.If the firm has a capital budget of $1,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

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

The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute or controversy?

Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

Suppose a new company decides to raise its initial $200 million of capital as $100 million of common equity and $100 million of long-term debt.By an iron-clad provision in its charter, the company can never borrow any more money.Which of the following statements is correct?

Takeda Enterprises has four investment opportunities with the following costs (all costs are paid at t = 0) and estimated internal rates of return (IRR): The company wants to maintain a capital structure of 50 percent debt and 50 percent equity.The company anticipates that it can issue up to $2,000 of debt at an interest rate of 10 percent; if it issues more than $2,000 of debt its interest rate will increase to 11 percent.The company's stock price (P₀) is currently $90 per share, its expected dividend ( ) is $6, and its dividend growth rate is 5 percent.The company expects to have $3,000 in retained earnings and its tax rate is 30 percent.What percentage flotation cost makes the net present value of accepting Project D zero? (Hint: Project D will be selected only after Projects A, B, and C have been selected.)

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' WACC once it starts using new common stock financing?

The cost of equity obtained by retaining earnings is generally regarded as being the rate of return stockholders require on the firm's common stock.

Which of the following statements is correct?

The expected rate of return on a constant growth stock is equal to the ____ plus its ____.

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting?

The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock.

Which of the following statements is most correct?

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' component cost of debt?

Which of the following may be true concerning debt and equity?