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Exam 9: The cost of capital

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Question 1

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

A) True
B) False

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Question 2

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Which of the following statements is CORRECT?

A) The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
B) The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
C) There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
D) The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
E) The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.

F) A) and E)
G) B) and E)

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Question 3

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Suppose you are the president of a small, publicly-traded corporation.Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity.You obtained the following data: D? = $1.25; P? = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method.However, only the DCF method is widely used in practice.

To help them estimate the company's cost of capital, Smithco has hired you as a consultant.You have been provided with the following data: D? = $1.45; P? = $22.50; and g = 6.50% (constant) .Based on the DCF approach, what is the cost of common from reinvested earnings?

Perpetual preferred stock from Franklin Inc.sells for $97.50 per share, and it pays an $8.50 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors.What is the company's cost of preferred stock for use in calculating the WACC?

A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

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.What is the best estimate of the after-tax cost of debt?

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division.Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC.She also believes that the data processing and manufacturing divisions have the same risk as their typical peers.Consequently, she estimates that the composite, or corporate, WACC is 11%.A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division.However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions.Which of the following statements is CORRECT?

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method.All this makes it especially difficult to estimate the cost of equity for a private company.

The cost of external equity capital raised by issuing new common stock (r?)is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Burnham Brothers Inc.has no retained earnings since it has always paid out all of its earnings as dividends.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt.Which of the following events would REDUCE its WACC?

Which of the following statements is CORRECT?

With its current financial policies, Flagstaff Inc.will have to issue new common stock to fund its capital budget.Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

To estimate the company's WACC, Marshall Inc.recently hired you as a consultant.You have obtained the following information.(1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1, 000, and a market price of $1, 050.00.(2) The company's tax rate is 40%.(3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20.(4) The target capital structure consists of 35% debt and the balance is common equity.The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares.What is its WACC?

For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital¾i.e., use these funds first¾because reinvested earnings have no cost to the firm.

Kenny Electric Company's noncallable bonds were issued several years ago and now have 20 years to maturity.These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1, 075, and has a par value of $1, 000.If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

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