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Exam 11: Determining the Cost of Capital

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Question 31

True/False

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

A) True
B) False

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Question 32

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Bloom and Co. has no debt or preferred stockσit uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept?

A) a division y project with a 12% return.
B) a division x project with an 11% return.
C) a division x project with a 9% return.
D) a division y project with an 11% return.
E) a division y project with a 13% return.

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

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Question 33

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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?

Since 70% of the preferred dividends received by a corporation are 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, beσσCost of equity = rs(0.30)(0.50) + rps(1 σ-T)(0.70)(0.50).

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.

Collins Group 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. $\begin{array}{l}\text { Assets }\\\begin{array}{lr}\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000\\\text { Total assets }&\$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt }(40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000\\\text { Total liabilities }&\$ 59,000,000 \\\text { Common stock ( } 10,000,000 \text { shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\ \text { Total shareholders' equity } & 80,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}\end{array}$ 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 the data for the Collins Group. Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

The president and CFO of Spellman Transportation are having a disagreement about whether to use market value or book value weights in calculating the WACC. Spellman'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 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, rs, 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?

Suppose Acme Industries 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

As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and gL = 8.00% (constant) . What is the cost of common from reinvested earnings based on the dividend growth approach?

Westbrook's Painting Co. plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

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?

If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to 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). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.

The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation?

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

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?

When working with the CAPM, which of the following factors can be determined with the most precision?

The cost of external equity capital raised by issuing new common stock (re) 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)."