Exam 13: The Cost of Capital

To attract capital from outside investors, a firm must offer potential investors an expected return that is commensurate with the level of risk that they can bear.

Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?

What is the assumption about leverage when using WACC to evaluate a project?

Assume the market value of Fords' equity, preferred stock and debt are $7 billion, $4 billion and $10 billion respectively. Ford has a beta of 1.4, the market risk premium is 6% and the risk-free rate of interest is 4%. Ford's preferred stock pays a dividend of $3 each year and trades at a price of $25 per share. Ford's debt trades with a yield to maturity of 8.5%. What is Ford's weighted average cost of capital if its tax rate is 35%?

What is the assumption about risk when using WACC to evaluate a project?

The fact that the after-tax cost of debt is lower than the pretax cost of debt implicitly assumes that interest expense can be ________.

Assume Time Warner shares have a market capitalization of $65 billion. The company just paid a dividend of $0.40 per share and each share trades for $25. The growth rate in dividends is expected to be 7.00% per year. Also, Time Warner has $10 billion of debt that trades with a yield to maturity of 7%. If the firm's tax rate is 40%, compute the WACC?

A firm has outstanding debt with a coupon rate of 8%, seven years maturity, and a price of $1,000. What is the after-tax cost of debt if the marginal tax rate of the firm is 35%?

The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate.

A firm's overall cost of capital that is a blend of the costs of the different sources of capital is known as the firm's ________.

A firm's cost of debt is the rate of interest it would have to pay to refinance its existing debt.

Assume SAP Inc. received a $2 million grant under its Small Business Innovation program. SAP invested the grant money and developed a system to remove metal contaminants from storm water in shipyards. The firm estimates that each shipyard spends $600,000 a year on storm water clean-up efforts. If SAP is able to sign up and retain four shipyards from the first year onwards, what is the present value (PV) of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other costs for SAP equal 60% of revenue.

Verano Inc. has two business divisions-a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 11% and the waste water clean-up business has a cost of equity capital of 4%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

Outstanding debt of Home Depot trades with a yield to maturity of 5%. The tax rate of Home Depot is 40%. What is the effective cost of debt of Home Depot?

When we use the WACC to assess a project, we assume that the ________ ratio does not change.

Many financial managers use market risk premiums that are closer to 5%, which is lower than historical averages, because ________.

Verano Inc. has two business divisions-a software product line and a waste water clean-up product line. The software business has a cost of equity capital of 10% and the waste water clean-up business has a cost of equity capital of 8%. Verano has 50% of its revenue from software and the rest from the waste water business. Verano is considering a purchase of another company in the waste water business using equity financing. What is the appropriate cost of capital to evaluate the business?

Outstanding debt of Home Depot trades with a yield to maturity of 7%. The tax rate of Home Depot is 35%. What is the effective cost of debt of Home Depot?

A firm incurs $35,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?

The WACC does not depend on the risk of a company's line of business.