Exam 9: The cost of capital

When working with the CAPM, which of the following factors can be determined with the most precision?

The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted, what is likely to happen over time?

You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital.You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30.Based on the CAPM approach, what is the cost of common from reinvested earnings?

When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return.This problem leaves us unsure of the true value of rs.

Quinlan Enterprises stock trades for $52.50 per share.It is expected to pay a $2.50 dividend at year end (D? = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year.The before-tax cost of debt is 7.50%, and the tax rate is 40%.The target capital structure consists of 45% debt and 55% common equity.What is the company's WACC if all the equity used is from reinvested earnings?

Which of the following statements is CORRECT?

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk, and the projects within the divisions may also vary in risk.Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50)+ rps(1 - T)(0.70)(0.50).

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

Exhibit 9.1 The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital.The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1, 000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00.The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%.The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years.The firm's tax rate is 40%. -Refer to Exhibit 9.1.Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

Westbrook's Painting Co.plans to issue a $1, 000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually.The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%.By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

Your consultant firm has been hired by Eco Brothers Inc.to help them estimate the cost of common equity.The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt.What is an estimate of the firm's cost of common from reinvested earnings?

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

When estimating the cost of equity by use of the CAPM, three potential problems are (1)whether to use long-term or short-term rates for rRF, (2)whether or not the historical beta is the beta that investors use when evaluating the stock, and (3)how to measure the market risk premium, RPM.These problems leave us unsure of the true value of rs.

If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms.Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity.However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

"Capital" is sometimes defined as funds supplied to a firm by investors.

In general, firms should use their weighted average cost of capital (WACC)to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources.However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.