Chapter 13

Marginal Incorporated (MI) has determined that its after-tax cost of debt is 7.0%. Its cost of preferred stock is 14.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 21.0%. Currently, the firm's capital structure has $621 million of debt, $45 million of preferred stock, and $234 million of common equity. The firm's marginal tax rate is 25%. The firm is currently making projections for the next period. Its managers have determined that the firm should have $99 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $465 million?

10.99 debt = 621 /900 = 0.69 pref = 45 / 900 = .05 eq = 234 / 900 = .26 + =900 breakpoint = 99/.26 = 300.77 465 is greater than breakpoint so, (.69)(7)+(.05)(14)+(.26)(21) = 10.99

Costly Corporation is considering a new preferred stock issue. The preferred would have a par value of $1000 with an annual dividend equal to 10.0% of par. The company believes that the market value of the stock would be $954.00 per share with flotation costs of $67.00 per share. The firm's marginal tax rate is 40%. What is the firm's cost of preferred stock?

11.27 n =1000 pv= 954-67 = 887 (input as negative in pv ) pmt = (1000)(.10)

Costly Corporation plans a new issue of bonds with a par value of $1000, a maturity of 30 years, and an annual coupon rate of 13.0%. Flotation costs associated with a new debt issue would equal 8.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds of firms similar to Costly is 17.0%. The firm's marginal tax rate is 30%. What will the firm's true cost of debt be for this new bond issue?

12.93 1. n=30 i=17 fv=1000 pmt=(.13)(1000) solve for pv = -766.82 2. n=30 pv = 766.82-(0.08)(766.82) = 705.47 (input as negative in pv ) fv= 1000 pmt = (.13)(1000) solve for i = 18.48 3. (18.48)(1-.30)=12.936

Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $31.00 per share. The firm's dividend for next year is expected to be $4.30 with an annual growth rate of 6.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 13.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external equity?

21.94 4.30/ (31-(.13)(31))+.06= 21.94

Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $29.00 per share. The firm's dividend for next year is expected to be $5.30 with an annual growth rate of 5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of internal equity?

23.28 5.30/29+0.05

Marginal Incorporated (MI) has determined that its before-tax cost of debt is 5.0% for the first $198 million in bonds it issues, and 8.0% for any bonds issued above $198 million. Its cost of preferred stock is 11.0%. Its cost of internal equity is 16.0%, and its cost of external equity is 20.0%. Currently, the firm's capital structure has $310 million of debt, $30 million of preferred stock, and $160 million of common equity. The firm's marginal tax rate is 35%. The firm's managers have determined that the firm should have $73 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $274 million?

9.08 debt = 310 / 500 = .62 pref = 30 / 500 = .06 equity = 160 / 500 = .32 + 500 breakpoint = 73/.32 = 228.25 274 is greater than breakpoint so, (.62)(5)(1-.35)+(.06)(11)+(.32)(20) = 9.075

The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.

false

The cost of new common stock (external equity) is generally higher than the cost of retained earnings (internal equity) because of:

flotation costs

High beta projects are projects with _________ risk and should be evaluated using a _______ cost of equity capital.

high;high

When calculating the component cost of debt for capital budgeting purposes for profitable, tax-paying firms, the tax adjustment:

reduces the component cost of debt

Since retained earnings are generated by the firm:

the funds have a positive cost that is less than new equity issues.

The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component that makes up the firm's target capital structure.

true