Chapter 14: Cost of Capital

Barry Corporation 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 is 5%. What is the value of Barry Corporation today?

$1,571,429 V0 = $110,000/(0.12-0.05) = $1,571,429

MNO preferred stock pays a dividend of $2 per year and has a price of $20. If MNO's tax rate is 21%, the required rate of return on its preferred stock is

10 ($2/$20=10%)

A firm'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 = .4*2.5%+.6*15%)

The CAPM formula is:

E(RE) = Rf + B(E(RM)−Rf)

True or false: Projects should always be discounted at the firm's overall cost of capital.

False (Projects' discount rates should reflect their particular level of risk.)

Which of the following methods for calculating the cost of equity ignores risk?

The dividend growth model

Which of the following variables is NOT required when using the CAPM to compute the cost of equity capital?

The rate of inflation

To estimate the growth rate of a particular stock, we can _______.

Use the historical dividend growth rate. Use security analysts' forecasts.

Some risk adjustment to a firm's WACC for projects of differing risk, even if it is subjective, is probably:

better than no risk adjustment

Dividends paid to common stockholders ___________ be deducted from the payer's taxable income for tax purposes.

cannot

WACC is used to discount ______ _________.

cash flows

One method for estimating the cost of equity is based on the ___________ model.

dividend growth

An important advantage to a firm raising equity internally is not having to pay _________.

flotation costs

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

If a firm issues no debt, its average cost of capital will equal ____.

its cost of equity

Preferred stock _____.

pays a constant dividend pays dividends in perpetuity

Other companies that specialize only in projects similar to the project your firm is considering are called _____.

pure plays

A project should only be accepted if its return is above what is ________.

required by investors

If a firm uses its overall cost of capital to discount cash flows from projects in higher risk divisions, it will accept ____ projects.

too many high-risk

A good source for bond quotes is:

www.finra.org/marketdata

A firm needs to sell enough equity to raise $950,000 after covering the flotation costs of 5%. How much will it pay in flotation costs?

$50,000 Calculation $950,000 = Amount Raised * (1-0.05) Amount Raised = $1,000,000 Flotation Costs = $1,000,000-950,000 = $50,000

What are the after-tax earnings for HIJ Corporation if it reports $200 in revenue, $90 in operating expenses, has a tax rate of 21%, and pays $20 in interest on its bonds.

$71.10 ($200-$90-$20)*(1-0.3)

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 Calculation f0 = 0.2*5%+0.8*10%=9% $9,100/(1-0.09)-$9,100 = $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 ($1,000,000-50,000=$950,000)

The rate used to discount project cash flows is known as the _______.

- discount rate - required return - cost of capital

The WACC is the minimum return a company needs to earn to satisfy ____________.

- its stockholders - its bondholders

Which of the following are tax-deductible to the firm?

Coupon interest paid on bonds

What is the required return on a stock (RE), according to the constant dividend growth model, if the growth rate (g) is zero?

RE = D1/P0

The market risk premium is defined as __________.

RM-Rf

The return an investor in a security receives is _________ _________ the cost of the security to the company that issued it.

equal to

The issuance costs of bonds and stocks are referred to as _______ costs.

flotation

To estimate a firm's equity cost of capital using the CAPM, we need to know the __________.

risk-free rate, stock's beta, market risk premium.

A company has a borrowing rate of 15 percent and a tax rate of 21 percent. What is its aftertax cost of debt?

11.85% (15%*(1-0.21)

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 rate is 21%. What is its WACC?

13.57% (0.7*0.16)+(0.3*0.1*(1-0.21))

Suppose the risk-free rate is 5 percent, the market rate of return is 10 percent, and beta is 2. Find the required rate of return using the CAPM

15% (5%+(2*(10%-5%))

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?

16% ($4+2*6%)

The formula for calculating the cost of equity capital that is based on the dividend discount model is:

RE = D1/P0 + g

Which of the following is true?

Under U.S. tax law, a corporation's interest payments are tax deductible.

Which of the following are true?

- Ideally, we should use market values in the WACC - Book values are often similar to market values for debt.

If an analyst's forecast for a firm's earnings growth is 7%, and its dividend yield is 3%, its cost of equity will be _____.

10% (Cost of Equity = Dividend yield + Growth rate = 3% + 7% = 10%)

Suppose a firm faces a risk-free rate of 2%, a beta of 1, and a market risk premium of 4%. What is its cost of capital if it is an all-equity firm?

6% (2%+1*4%)

WACC was used to compute the following project NPVs: Project A = $100, Project B = -$50, Project C = -$10, Project D = $40. Which project should the firm accept?

A and D

What does WACC stand for?

weighted average cost of capital

If an all-equity firm discounts a project's cash flows with the firm's overall weighted average cost of capital 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.

Dang's Donuts has EBIT of $25,432, depreciation of $1,500, and a tax rate of 21%. The company will not be changing its net working capital, but plans a capital expenditure of $6,324. What is Dang's adjusted cash flow from assets?

$15,267.28

If the market value of debt is $45 million and the market value of equity is $105 million, the total firm value is ________ million.

$150

If the market value of debt is $45 million and the market value of equity is $105 million, the total firm value is _________ million.

$150

Including preferred stock in the WACC adds the term:

(P/V)*RP

Which of the following are components used in the construction of the WACC?

- Cost of preferred stock - Cost of debt - Cost of common stock

The SML approach requires estimates of:

- market risk premium - beta coefficient

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

A firm has a target debt-equity ratio of 0.5, but it plans to finance a new project with all debt. What debt-equity ratio should be used when calculating the project's flotation costs?

0.5

According the weighted average cost of capital (WACC) formula, a firm with no debt or preferred stock will have a WACC of:

1*Cost of equity

If an all-equity firm's beta is 2, the risk-free rate is 3%, and the historical market risk premium is 7%, what is the firm's cost of capital?

17%

Sigma Corporation consists of two divisions: A and B. Division A is riskier than Division B. If Sigma Corporation uses the firm's overall WACC to evaluate both Division's projects, which Division will probably not receive enough resources to fund all of its potentially profitable projects?

Division B Explanation: Division A is riskier, so its cash flows should be discounted at a higher rate. Because they're not, the projects in Division A will look better than those in Division B. More projects will be accepted in Division A. Division B's cash flows will be discounted using a higher rate than should be used, so they will appear less appealing and will be more often rejected.

B = the market value of a firm's debt; S = the market value of that same firm's equity; RB = 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)]*RS+[B/(S+B)]*RS*(1-TC)

Economic Value Added (EVA) uses the weighted average cost of capital to determine if value is:

being created or destroyed

If the firm is all-equity, the discount rate is equal to the firm's cost of _____ capital

equity

The CAPM can be used to estimate the ________.

required return on equity