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Exam 10: The Cost of Capital

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Question 1

True/False

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The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

A) True
B) False

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True

Question 2

Multiple Choice

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You were hired as a consultant to Quigley Company,whose target capital structure is 35% debt,10% preferred,and 55% common equity.The interest rate on new debt is 6.50%,the yield on the preferred is 6.00%,the cost of retained earnings is 11.25%,and the tax rate is 40%.The firm will not be issuing any new stock.What is Quigley's WACC?

A) 8.15%
B) 8.48%
C) 8.82%
D) 9.17%
E) 9.54%

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

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Question 3

Multiple Choice

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Which of the following statements is CORRECT?

Trahan Lumber Company hired you to help estimate its cost of capital.You obtained the following data: D₁ = $1.25; P₀ = $27.50; g = 5.00% (constant) ; and F = 6.00%.What is the cost of equity raised by selling new common stock?

Bankston Corporation forecasts that if all of its existing financial policies are followed,its proposed capital budget would be so large that it would have to issue new common stock.Since new stock has a higher cost than retained earnings,Bankston would like to avoid issuing new stock.Which of the following actions would REDUCE its need to issue new common stock?

Assume that you are on the financial staff of Vanderheiden Inc.,and you have collected the following data: The yield on the company's outstanding bonds is 7.75%,its tax rate is 40%,the next expected dividend is $0.65 a share,the dividend is expected to grow at a constant rate of 6.00% a year,the price of the stock is $15.00 per share,the flotation cost for selling new shares is F = 10%,and the target capital structure is 45% debt and 55% common equity.What is the firm's WACC,assuming it must issue new stock to finance its capital budget?

Weaver Chocolate Co.expects to earn $3.50 per share during the current year,its expected dividend payout ratio is 65%,its expected constant dividend growth rate is 6.0%,and its common stock currently sells for $32.50 per share.New stock can be sold to the public at the current price,but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?

Which of the following statements is CORRECT?

Bosio Inc.'s perpetual preferred stock 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?

For a company whose target capital structure calls for 50% debt and 50% common equity,which of the following statements is CORRECT?

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

Exhibit 10.1 Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, 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 10.1.Which of the following is the best estimate for the weight of debt for use in calculating the WACC?

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

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,r_s,than on the interest rate on long-term debt,r_d,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.

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.This debt currently has a market value of $50 million.The balance sheet also shows that the company has 10 million shares of common stock,and the book value of the common equity (common stock plus retained earnings) is $65 million.The current stock price is $22.50 per share; stockholders' required return,r_s,is 14.00%; and the firm's tax rate is 40%.The CFO thinks the WACC should be based on market-value weights,but the president thinks book weights are more appropriate.What is the difference between these two WACCs?

O'Brien Inc.has the following data: r_RF = 5.00%; RP_M = 6.00%; and b = 1.05.What is the firm's cost of equity from retained earnings based on the CAPM?

If a typical U.S.company 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 r_RF,(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,RP_M.These problems leave us unsure of the true value of r_s.

You were hired as a consultant to Giambono Company,whose target capital structure is 40% debt,15% preferred,and 45% common equity.The after-tax cost of debt is 6.00%,the cost of preferred is 7.50%,and the cost of retained earnings is 12.75%.The firm will not be issuing any new stock.What is its WACC?

The cost of equity raised by retaining earnings can be less than,equal to,or greater than the cost of external equity raised by selling new issues of common stock,depending on tax rates,flotation costs,the attitude of investors,and other factors.