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Exam 12: The Cost of Capital

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Question 41

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The MCC schedule, as developed from the weighted average cost of capital, has a break point that occurs when retained earnings are used up.

A) True
B) False

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Question 42

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The cost of debt, r_d, is always less than r_s, so r_d(1 − T) will certainly be less than r_s.Therefore, since a firm cannot be 100% debt financed, the weighted average cost of capital will always be greater than r_d(1 − T).

A) True
B) False

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Question 43

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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.What is GEC's cost of equity from newly issued stock?

An increase in total assets can be financed by an increase in which of the following capital components:

MCC Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity.Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent.The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D₀) was $2.00; and the current equilibrium stock price is $21.88.Byron can raise all the debt financing it needs at 14.0 percent.If Byron issues new common stock, a 20 percent flotation cost will be incurred.The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18.0 percent.What is the weighted average cost of capital at that point?

Which of the following statements is most correct?

MCC Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity.Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent.The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D₀) was $2.00; and the current equilibrium stock price is $21.88.Byron can raise all the debt financing it needs at 14.0 percent.If Byron issues new common stock, a 20 percent flotation cost will be incurred.The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words, what is the retained earnings break point?)

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.

Flotation costs lower the cost of capital to a firm when issuing new securities.

Which of the following is not considered a capital component?

Cost of External Equity Becker Glass Corporation Becker Glass Corporation expects to have earnings before interest and taxes during the coming year of $1,000,000, and it expects its earnings and dividends to grow indefinitely at a constant annual rate of 12.5 percent.The firm has $5,000,000 of debt outstanding bearing a coupon interest rate of 8 percent, and it has 100,000 shares of common stock outstanding.Historically, Becker has paid 50 percent of net earnings to common shareholders in the form of dividends.The current price of Becker's common stock is $40, but it would incur a 10 percent flotation cost if it were to sell new stock.The firm's tax rate is 40 percent. -Refer to Becker Glass Corporation.What is Becker's cost of newly issued stock?

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

Since 70 percent of preferred dividends received by a corporation is 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 = r_s(0.30)(0.50) + r_s(1 − T)(0.70)(0.50).

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.Where will a break in the WACC curve occur?

WACC Above Break Point Jackson Company The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely.The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent.The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. -Refer to Jackson Company.What will be Jackson's cost of new common stock if it issues new stock in the marketplace today?

Retained earnings costs are lower than the costs of newly issued equity since a new issue will have flotation costs.

Heavy Metal Corp.is a steel manufacturer that finances its operations with 40 percent debt, 10 percent preferred stock, and 50 percent equity.Its net income is $100 million and it has a payout ratio of 35 percent.The interest rate on the company's debt is 11 percent.The preferred stock pays an annual dividend of $2 and sells for $20 a share.The company's common stock trades at $30 a share and its current dividend (D₀) of $2 a share is expected to grow at a constant rate of 8 percent per year.The flotation cost of external equity is 15 percent of the dollar amount issued, while the flotation cost on preferred stock is 10 percent.The company estimates that its WACC is 12.30 percent.Assume that the company is raising $150 million in total capital.What is the company's tax rate?

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 common stock?

The items in the asset section of the balance are its capital components.

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 retained earnings?