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Exam 13: Cost of Capital

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Question 91

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Which of the following statements about the marginal cost of capital (MCC) and the investment opportunity schedule (IOS) is incorrect?

A) A company's WACC for the planning period is at the intersection of the MCC and the IOS.
B) The MCC will break when low cost debt runs out and is replaced with higher cost debt.
C) The IOS ranks projects from highest to lowest according to their individual NPV's.
D) A break in the MCC may occur because of the floatation costs associated with issuing new stock.
E) All of the above statements are correct.

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Question 92

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The returns investors receive are related to but not equal to the firm's component costs of capital.

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Question 93

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The weighted-average cost of capital:

Your company is expected to earn $4.0 million in net income next year of which it will pay out 40% in dividends. If equity represents 50% of your capital, what is the breakpoint on the MCC where new stock will have to be issued?

In the calculation of the component cost of a firm's debt, the yield-to-maturity on the firm's bonds:

Although preferred stock is legally a form of equity, it is often referred to as a hybrid security:

If a firm had the following mix of capital components: $\begin{array}{ll}\text { Debt } & \$ 25,000 \\\text { Preferred stock } & \$ 20,000 \\\text { Common stock } & \$ 55,000\end{array}$ its capital structure would be described as:

Groves, Inc. pays an annual dividend of $1.22, which is expected to grow at a rate of 5 percent each year. The firm is in a fairly risky business and has a beta of 1.45. The return on the market is 13.5 percent, and the risk-free rate is 9.3 percent. What is the cost of Groves' equity from retained earnings?

It is typical to expect the first increase in the marginal cost of capital to occur when the firm exhausts its retained earnings and proceeds to raise capital by issuing debt.

The book value of a company's capital represents the money the firm actually has. It can do whatever it wants with that money. Right?!?! Why then do authorities claim that market values of capital are appropriate for calculating the WACC.

Separately funded projects:

Assume a firm's bonds are currently yielding new investors 6%. The combined federal and state tax rate is 40%. What is the firm's after-tax cost of debt is?

The difference between the riskiness of debt and equity is relatively constant between companies, and tends to command an additional risk premium of 3% to 5%.

A company's cost of capital can be thought of as a required return for all capital budgeting projects that have risk levels approximately equal to its own.

The CAPM's estimate of the component cost of common equity would be increased by an increase in:

Johnston Corp has 10,000 bonds outstanding that were issued for 30 years ten years ago at a par value of $1,000 and a coupon rate of 12%. Similar bonds are now selling to yield 9%. It issued 40,000 shares of 6% preferred stock at a $100 par value eight years ago. Those preferred shares are now selling to yield 10%, and are subject to an 8% flotation cost. There are currently 2,500,000 of common stock outstanding selling for $11.60 a share. Johnston's cost of equity is 14% Develop Johnston's market value based capital structure, and calculate its WACC. Assume equity capital comes from retained earnings, and the marginal tax rate is 40%.

Calculate the WACC. $\begin{array}{lll}&\text { Value } & \text { Cost } \\\text { Debt } & \$ 50 & 6 \% \\\text { Preferred } & \$ 10 & 9 \% \\\text { Equity } & \$ 90 & 12 \%\\&\$150\end{array}$

Retained earnings are not free because stockholders deserve a return on invested funds regardless of the source of those funds.

The following financial information is available on Rawls Manufacturing Company: $\begin{array}{lr}\text {Current per share market price }&\$48.00\\\text { Most recent per share dividend }&\$3.50\\\text { Expected long-term growth rate}&5.0\%\\\end{array}$ Rawls can issue new common stock to net the company $44 per share. Determine the cost of retained earnings using the dividend growth model approach. (Compute answer to the nearest .1%) .

All of the following represent adjustments to the cost of capital components except: