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Exam 11: The Cost of Capital

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Question 31

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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. Assets ​ Liabilities and Equity The stock is currently selling for $15.25 per share,and its noncallable $1,000.00 par value,20-year,9.00% bonds with semiannual payments are selling for $930.41.The beta is 1.22,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 25%. -Refer to Exhibit 10.1.What is the best estimate of the after-tax cost of debt?

A) 5.23%
B) 5.59%
C) 7.35%
D) 6.17%
E) 6.48%

F) C) and D)
G) C) and E)

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Question 32

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Assume that you are a consultant to Broske Inc. ,and you have been provided with the following data: D₁ = $0.67;P₀ = $47.50;and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

A) 9.50%
B) 9.41%
C) 8.19%
D) 10.63%
E) 7.25%

F) B) and D)
G) A) and C)

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Question 33

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The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

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.

Assume that Kish Inc.hired you as a consultant to help estimate its cost of capital.You have obtained the following data: D₀ = $0.90;P₀ = $47.50;and g = 7.00% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings? Do not round your intermediate calculations.

Bosio Inc.'s perpetual preferred stock sells for $102.50 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?

Rivoli Inc.hired you as a consultant to help estimate its cost of capital.You have been provided with the following data: D₀ = $0.80;P₀ = $35.00;and g = 8.00% (constant) .Based on the DCF approach,what is the cost of equity from retained earnings? Do not round your intermediate calculations.

Which of the following statements is CORRECT?

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

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.

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.No adjustment is needed for taxes because preferred dividends,unlike interest on debt,are not deductible by the issuing firm.

The cost of debt,r_d,is normally less than r_s,so r_d(1 - T)will normally be much less than r_s.Therefore,as long as the firm is not completely debt financed,the weighted average cost of capital (WACC)will normally be greater than r_d(1 - T).

Several years ago the Jakob Company sold a $1,000 par value,noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually.The bond currently sells for $875 and the company's tax rate is 25%.What is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations.

The MacMillen 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?

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. Assets ​ Liabilities and Equity The stock is currently selling for $15.25 per share,and its noncallable $1,000.00 par value,20-year,9.00% bonds with semiannual payments are selling for $930.41.The beta is 1.22,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 25%. -Refer to Exhibit 10.1.What is the best estimate of the firm's WACC? Do not round your intermediate calculations.

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

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method,the DCF method,and the bond-yield-plus-risk-premium method.However,only the DCF method is widely used in practice.

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.

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.

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 r_s.