Exam 12: The Cost of Capital

Bouchard Company's stock sells for $20 per share, its last dividend (D₀) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock.Retained earnings for the coming year are expected to be $1,000,000, and the common equity ratio is 60 percent.If Bouchard has a capital budget of $2,000,000, what component cost of common equity will be built into the WACC for the last dollar of capital the company raises?

The lower the firm's tax rate, the lower will be the firm's after-tax cost of debt and WACC, other things held constant.

Typically, according to the text, the MCC schedule is either horizontal or rising, which implies that the cost of capital to a firm increases as it raises larger and larger amounts of capital.The rising section of MCC schedule

Capital refers to items on the right-hand side of a firm's balance sheet.

The cost of equity capital from the sale of new common stock (r_e) is generally equal to the cost of equity capital from retention of earnings (r_s), divided by one minus the flotation cost as a percentage of sales price (1 − F).

Flotation and WACC Gulf Electric Company (GEC) Gulf Electric Company (GEC) uses only debt and equity in its capital structure.It can borrow unlimited amounts at an interest rate of 10 percent so long as it finances at its target capital structure, which calls for 55 percent debt and 45 percent common equity.Its last dividend was $2.20; its expected constant growth rate is 6 percent; its stock sells on the NYSE at a price of $35; and new stock would net the company $30 per share after flotation costs.GEC's tax rate is 40 percent, and it expects to have $100 million of retained earnings this year.GEC has two projects available: Project A has a cost of $200 million and a rate of return of 13 percent, while Project B has a cost of $125 million and a rate of return of 10 percent.All of the company's potential projects are equally risky. -Refer to Gulf Electric Company.Assume now that GEC needs to raise $300 million in new capital.What is GEC's marginal cost of capital for evaluating the $300 million in capital projects and any others that might arise during the year?

What is the best data to use for the growth rate estimate for DCF cost of capital estimates?

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 is the firm's cost of newly issued preferred stock?

The weighted average cost of capital should be used when making investment decisions regardless of the specific financing used to fund a project.

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' cost of retained earnings using the bond-yield-plus-risk-premium approach?

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' cost of retained earnings using the CAPM approach?

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 expected after-tax cost of this debt issue?

The after-tax cost of debt is always less than the before-tax cost of debt for all firms.

The firm's cost of capital represents the maximum rate of return earned on the firm's investments.

The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock.