Exam 12: The Cost of Capital

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds does have a cost.

For a typical firm with a given capital structure, which of the following is correct? (Note: r_a = WACC, and all rates are after taxes.)

Assume that a firm's financial analysts determine that a decrease in the firm's debt-to-assets ratio will cause a decrease in both the component cost of debt r_d(1 − T) and the component cost of equity (r_s).This information tells us that the firm's present debt-to-assets ratio is above its optimal ratio.

Publicly placed bonds do not typically involve flotation costs due to the availability of publicly placed funds, but privately placed debt typically does involve flotation costs because of the difficulty involved in raising private funds.

Which of the following statements is false?

The investment opportunity schedule is a graph of the firm's investment opportunities ranked in order of the projects' expected rates of return.

Which of the following statements is correct?

WACC Above Break Point Gargoyle Unlimited Gargoyle Unlimited is planning to issue a zero coupon bond to fund a project that will yield its first positive cash flow in three years.That cash flow will be sufficient to pay off the entire debt issue.The bond's par value will be $1,000, it will mature in 3 years, and it will sell in the market for $727.25.The firm's marginal tax rate is 40 percent. -Refer to Gargoyle Unlimited.What is the dollar value of the interest tax savings to the firm in the third year of the issue?

WACC Above Break Point Jackson Company The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely.The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent.The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. -Refer to Jackson Company.How much should an investor be willing to pay for this stock today?

Which of the following statements is most correct?

Martin Corporation's common stock is currently selling for $50 per share.The current dividend is $2.00 per share.If dividends are expected to grow at 6 percent per year and if flotation costs are 10 percent, then what is the firm's cost of retained earnings and what is its cost of new common stock?

The cost of capital used to evaluate investment opportunities should be calculated as a weighted average of the various types of funds generally used, regardless of the specific financing used to fund a particular project.

Which of the following statements is most correct?

Which of the following statements is correct?

Which of the following statements is correct?

It is not possible for a firm's use of debt to increase but its after-tax cost of debt to decline.

Which of the following statements is correct?

The cost of capital should reflect the average cost of the various sources of long-term funds a firm uses to support its assets.

Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources.However, when the firm plans on using only debt or only equity to fund a particular project, it should use the after-tax cost of the specific source of capital to evaluate that project.

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