Ch 14: Cost of Capital
Fashion Wear has bonds outstanding that mature in 12 years, pay interest annually, and have a coupon rate of 7.5 percent. These bonds have a face value of $1,000 and a current market price of $1,060. What is the company's aftertax cost of debt if its tax rate is 35 percent?
$1,060 = (.075 × $1,000) × ({1 - [1 / (1 + r)12]} / r) + $1,000 / (1 + r)12 Using trial-and-error, a financial calculator, or a computer, r = 6.75 percent Aftertax cost of debt = 6.75 percent × (1 - .35) = 4.39%
Hydro Systems has 15-year bonds outstanding with a coupon rate of 6 percent. Interest is paid annually. The face amount of each bond is $1,000. What is the company's pre-tax cost of debt if the bonds currently sell for $1,080?
$1,080 = (.06 x $1,000)x((1-(1/r)¹⁵))/r)+$1,000/(1+r)¹⁵ r=5.22%
Dang's Donuts has EBIT of $25,432, depreciation of $1,500, and a tax rate of 18%. The company will not be changing its net working capital, but plans a capital expenditure of $6,324. What is Dant's adjusted cash flow from assets?
$16,030.24
A firm needs to raise $950,000 but will incur flotation costs of 5%. How much will it pay in flotation costs?
$50,000
ULC and LEV have earnings before interest and taxes of $110. LEV also has $20 of interest expense. Both companies are taxed at 30%, ULC's aftertax earnings are,
$77, which is $14 greater than LEV's aftertax earnings.
A firm has 20% debt, debt flotation costs of 5%, equity flotation costs of 10%, and wants to raise $9,100, not including flotation costs. What are the flotation costs?
$900
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
$950,000
If a firm uses PREFERRED stock in its capital structure, the expression for the WACC will include...
(P/V) x R∨P
Values used for WACC
*Book values are often similar to market values for debt *Ideally, we should use market values in the WACC
Components used to constuct the WACC.
*Cost of Debt (R∨D) *Cost of common stock (R∨E) *Cost of preferred stock (R∨P)
What can we say about the dividends paid to common and preferred stockholders?
*Dividends to preferred stockholders are fixed *Dividends to common stockholders are not fixed
If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to do all of the following:
*Reject some positive net present value projects. *Increase the firm's overall level of risk over time *Accept some negative net present value projects *Favor high risk projects over low risk projects *WILL NOT, Lower the average risk level of the firm over time.
The rate used to discount project cash flows is known as the...
*discount rate *required return *cost of capital
Preferred stock pays..
*dividends in perpetuity *a constant dividend
A firm's cost of debt can be...
*obtained by checking yields on publicly traded bonds *estimated easier than its cost of equity *obtained by talking to investment bankers
The SML approach requires estimates of:
*the market risk premium *the beta coefficient
If an analyst's forecast for a firm's earning growth is 7%, and its dividend yield is 3%, its cost of equity will be...
.03 + .07 = .10
A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. With debt-equity ratio should be used when calculating the project's flotation costs?
.5
If the firm issued so much debt that its equity was valueless, its average cost of capital would equal...
1 x the aftertax cost of debt
Chelsea Fashions is expected to pay an annual dividend of $1.10 a share next year. The market price of the stock is $21.80 and the growth rate is 4.5 percent. What is the firm's cost of equity?
1.10/21.80+.045 = 9.55%
A firms's capital structure consists of 40% debt and 60% equity. The aftertax yield on debt is 2.5% and the cost of equity is 15%. The project is about as risky as the overall firm. What discount rate should be used to estimate the project's net present value?
10%
WACC was used to compute the following project NPVs: Project A= $100, Project B = -$50, Project C = -$10, Project D = $40. Which projects should the firm accept?
A and D
The Daily Brew has a debt-equity ratio of .64. The firm is analyzing a new project that requires an initial cash outlay of $420,000 for equipment. The flotation cost is 9.6 percent for equity and 5.4 percent for debt. What is the initial cost of the project including the flotation costs?
Average flotation cost = (1/ 1.64)(.096) + (.64 / 1.64)(.054) = .07961 Initial cost = $420,000 / (1 - .07961) = $456,328
Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 16.8 percent, and a cost of preferred stock of 9.1 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company's tax rate is 34 percent. What is the firm's weighted average cost of capital?
D = 1.012 × $550,000 = $556,600 P = 25,000 × $41 = $1,025,000 E = 220,000 × $27= $5,940,000 V = $556,600 + 1,025,000 + 5,940,000 = $7,521,600 WACC = ($5,940,000 / $7,521,600)(.168) + ($1,025,000 / $7,521,600)(.091) + ($556,600 / $7,521,600)(.076)(1 - .34) = .1488, or 14.88%
Sigma Corp consists of two divisions: Div A is riskier than Div B. If Sigma Corp uses the firm's overall WACC to evaluate both Divisions' projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?
Division B
Barry Corp expects free cash flow of $110 thousand at the end of the year, and steady growth from here on. Its WACC is 12% and its expected growth rate (g) is 5%. What is the value of Barry Corp today?
Firm value today = V₀ = CFA₁* / WACC-g = $110 / .12 - .05 = $1,571,429
The pre-tax cost of debt
Is based on the current yield to maturity of the firm's outstanding bonds
Grill Works has 7 percent preferred stock outstanding that is currently selling for $49 a share. The market rate of return is 14 percent and the firm's tax rate is 37 percent. What is the firm's cost of preferred stock?
RP = (.07 × $100) / $49 = .1429, or 14.29%
The cost of preferred stock is computed the same as the:
Rate of return on a perpetuity.
What is the required return on a stock (R∨E), according to the constant dividend growth model, if the growth rate (g) is zero?
R∨E = D∨1 / P∨0
If the risk-free rate is 4%, an all-equity firm's beta is 2, and the market risk premium is 6%, what is the firm's cost of capital?
R∨E = R∨f + β x (R∨M - R∨f) R=R∨f + β x MRP .04 + 2 x .06 = .16
To estimate a firm's equity cost of captial (R∨E), we need to know the
R∨E = R∨f + β x (R∨M - R∨f) R∨E = R∨f + β x MRP *Risk-free rate (R∨f) *stock's Beta (β) *Market risk premium (R∨M - R∨f)
Suppose the risk-free (R∨f) rate is 5%, the market rate of return is 10%, and the beta (β) is 2. Find the required rate of return (R∨E) using CAPM.
R∨E = R∨f + β x (R∨M - R∨f) = 05 + 2 x (.10-.05) = 15%
If a preferred stock pays a dividend of $2 per year and is selling for $20, its yield is:
R∨P = D / P₀ 2 / 20 = 10%
For a firm that uses debt in its capital structure, how is the WACC affected
The WACC should decrease as the firm's debt-equity ratio increases
According to the CAPM, what is the expected return on a stock if its beta is equal to zero?
The risk-free rate
Kelso's has a debt-equity ratio of .6 and a tax rate of 35 percent. The firm does not issue preferred stock. The cost of equity is 14.5 percent and the aftertax cost of debt is 4.8 percent. What is the weighted average cost of capital?
WACC = (1 / 1.6) (.145) + (.6 / 1.6) (.048) = .1086, or 10.86%
A firm's capital structure consists of 30% debt and 70% equity. Its bonds yield 10%, pretax, its cost of equity is 16%, and the tax is 40%. What is its WACC?
WACC = (E/V) x R∨E + (D/V) x R∨D x (1-T) = (0.7 x 16%) + (0.3 x 10% x (1 - 0.4)) = 13%
The average of a firm's cost of equity and aftertax cost of debt that is weighted based on the firm's capital structure is called the
Weighted average cost of capital
What does WACC stand for?
Weighted average cost of capital
B = the market value of a firm's debt; S = the market value of that same firm's equity; Rs = the before-tax yield on the firm's debt; Tc = the corporate tax rate; Rs = the cost of equity. Given the definitions above, the weighted average cost of capital formula can be written as :
[S/(S+B)] x Rs + [B/(S+B)] x Rs x (1-Tc)
If a firm has multiple projects, each project should be discounted using...
a discount rate commensurate with the project's risk
The best way to include flotation costs is to
add them to the initial investment
The discount rate for the firm's projects equals the cost of capital for the firm as a whole when...
all projects have the same risk as the current firm
Economic Value Added (EVA) uses the weighted average cost of capital to determine if value is:
being created or destroyed
Some risk adjustments to a firm's WACC for projects of differing risk, even if it is subjective, is probably:
better than no risk adjustment
Flotation costs are costs incurred to
bring new security issues to the market
WACC is used to discount.....
cash flows
One method for estimating the cost of equity is based on the
dividend growth model
An important advantage to a firm raising equity internally is not having to pay
flotation costs
When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should:
increase the initial project cost by dividing that cost by (1 - .068).
In reality, most firms cover the equity portion of their capital spending with...
internally generated cash flow
Finding a firm's overall cost of equity is difficult because:
it cannot be observed directly
The most appropriate weights to use in the WACC are the...
market value weights
Other companies that specialize only in projects similar to the project your firm is considering are called
pure plays
if an all-equity firm discounts a project's cash flows with the firm's overall WACC even though the project's beta is less than the firm's overall beta, it is possible that the project might be...
rejected, when it should be accepted
The CAPM can be used to estimate the
required return on equity
The cost of capital is an appropriate name since a project must earn enough to pay those who..
supply the capital
Under U.S. tax law, a corporation's interest payments are
tax deductible
Dividends paid to common stockholders cannot be deducted from the payer's...
taxable income for tax purposes
The return an investor in a security receives is equal to
the cost of the security to the company that issued it.
Method for calculating the cost of equity ignores risk
the dividend growth model
If a firm uses its overall cost of capital to discount cash flows from higher risk projects, it will accept...
too many high-risk projects
primary determinant of a firm's cost of capital
use of the funds
A good source for bond quotes is:
www.finra.org/marketdata
A project should only be accepted if its return is above what is required by..
the investors
The outstanding bonds of Tech Express are priced at $989 and mature in 10 years. These bonds have a face value of $1,000, a coupon rate of 6 percent, and pay interest annually. The firm's tax rate is 35 percent. What is the firm's aftertax cost of debt?
$989 = (.06 × $1,000) × ({1 - [1 / (1 + r)10]} / r) + $1,000 / (1 + r)10 Using trial-and-error, a financial calculator, or a computer, r = 6.15 percent Aftertax cost of debt = 6.15 percent × (1 - .35) = 4.00 percent
To estimate the growth rate of a particular stock, we can use...
*the historical dividend growth rate *security analysts' forecasts
A company has a borrowing rate of 15% and tax rate of 30%. What is its aftertax cost of debt?
.15 x (1-.3) = 10.5%
If an all-equity firm's beta is 2, the risk-free rate is 3%, and the historical maket risk premium is 7%, what is the cost of capital?
R∨E = R∨f + β x (R∨M - R∨f) = .03 + 2 x .07 = 17%
The WACC is the miniumum return a company needs to earn to satisfy...
the investors who supply capital. *its stockholders and its bondholders
The capital structure weights used in computing a firm's weighted average cost of capital:
Are based on the market values of the firm's debt and equity securities.
Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should:
Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values.
National Home Rentals has a beta of 1.24, a stock price of $22, and recently paid an annual dividend of $.94 a share. The dividend growth rate is 4.5 percent. The market has a 10.6 percent rate of return and a risk premium of 7.5 percent. What is the firm's cost of equity?
RE= (.106 - .075) + 1.24(.075) = .124 RE= [($.94 × 1.045) / $22] + .045 = .08965 REAverage = (.124 + .08965) / 2 = .1068, or 10.68%
The market risk premium is defined as
R∨M - R∨f
will increase a firm's aftertax cost of debt
a Decrease in the firm's tax rate.
Stock in Country Road Industries has a beta of 1.46. The market risk premium is 7.5 percent while T-bills are currently yielding 2.5 percent. Country Road's last dividend was $1.55 per share and dividends are expected to grow at an annual rate of 4.5 percent indefinitely. The stock sells for $26 a share. What is the estimated cost of equity using the average return of the CAPM and the dividend discount model?
RE = .025 + 1.46(.075) = .1345 RE = [($1.55 × 1.045) / $26] + .045 = .1073 RE Average = (.1345 + .1073) / 2 = .1209, or 12.09%
