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Exam 10: The Cost of Capital

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Question 51

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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.

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Question 52

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

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Question 53

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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 = $45.00;and g = 8.00% (constant) .What is the cost of equity from retained earnings based on the DCF approach?

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 $30.00 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? Do not round your intermediate calculations.

To help finance a major expansion,Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity.This bond has a 9.25% annual coupon,paid semiannually,sells at a price of $1,025,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? Do not round your intermediate calculations.

Schalheim Sisters Inc.has always paid out all of its earnings as dividends,hence the firm has no retained earnings.This same situation is expected to persist in the future.The company uses the CAPM to calculate its cost of equity,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?

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

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.

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

The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and retained earnings,whose cost is the average return on the assets that are acquired.

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 $17.00 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?

LaPango Inc.estimates that its average-risk projects have a WACC of 10%,its below-average risk projects have a WACC of 8%,and its above-average risk projects have a WACC of 12%.Which of the following projects (A,B,and C) should the company accept?

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500,while Firm W's earnings and stock price move counter cyclically with M and other S&P companies.Both M and W estimate their costs of equity using the CAPM,they have identical market values,their standard deviations of returns are identical,and they both finance only with common equity.Which of the following statements is CORRECT?