Chapter 10 - Cost of Capital
e
A company has outstanding long-term bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company were to issue new debt, what is a reasonable estimate of the interest rate (rd) on that debt? a. 6.2% b. 5.7% c. 8.0% d. 7.0% e. 9.0%
d
A company has outstanding long-term bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company's tax rate is 30%, what would be its after-tax cost of debt? a. 7.5% b. 7.0% c. 5.2% d. 6.3% e. 8.0%
e
A company's perpetual preferred stock pays a $4.50 annual dividend per share, and it currently sells for $60 per share. If the company were to sell a new preferred issue, what would be the cost of that capital? Ignore flotation costs. a. 8.3% b. 5.6% c. 6.4% d. 4.5% e. 7.5%
a
A company's perpetual preferred stock pays a $5 annual dividend per share, and it currently sells for $80 per share. If the company were to sell a new preferred issue, what is a good estimate of the cost of that capital? Ignore flotation costs. a. 6.25% b. 5.40% c. 5.00% d. 6.75% e. 7.33%
c
A firm has the following data: target capital structure of 50% debt and 50% common equity; tax rate = 40%; rd = 7.5%; and rs = 12%. Assume the firm will not be issuing new common stock. What is this firm's WACC? a. 10.0% b. 9.5% c. 8.3% d. 12.0% e. 7.5%
d
A firm must raise capital to build factories and purchase equipment to develop their products to sell. Which of the following is NOT one of the main sources of capital? a. Bonds b. Common equity c. Bank loans d. Inventory e. Preferred stock
new
A firm's before-tax cost of debt, rd, is the interest rate that the firm must pay on NEW OR OUTSTANDING DEBT?
c
A firm's target capital structure consists of 10% debt and 90% common equity. Its tax rate = 40%; rd = 6.5%; and rs = 9.5%. Assuming that the firm will not be issuing new common stock, what is its WACC? a. 10.33% b. 6.50% c. 8.94% d. 9.50% e. 8.25%
preferred stock
A special type of stock whose owners, though not generally having a say in running the company, have a claim to profits before other stockholders do.
b
All else equal, which of the following is most likely to increase a company's retained earnings breakpoint? a. An increase in the company's dividend payout ratio b. A decrease in the fraction of equity used in the company's target capital structure c. both factors will lead to an increase in the retained earnings breakpoint.
a
Among the following factors that affect the cost of capital, which can the firm most directly control? a. The firm's capital structure b. Interest rates c. Tax rates
true
An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant. True False
false
As a general rule, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects. After all, most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. True False
10.4275%
At the present time, Tamin Enterprises does not have any preferred stock outstanding but is looking to include preferred stock in its capital structure in the future. Tamin has found some institutional investors that are willing to purchase its preferred stock issue provided that it pays a perpetual dividend of $14 per share. If the investors pay $134.26 per share for their investment, then Tamin's cost of preferred stock (rounded to four decimal places) will be
6.66%
At the present time, Water and Power Company (WPC) has 10-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,092.79 per bond, carry a coupon rate of 11%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 30%. If WPC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.)
a
Barlett Co. has two divisions. Its risky division, Division R, has a WACC = 12%, while its safer division, Division S, has a WACC = 8%. Since the two divisions are the same size, the company's composite WACC is 10%. A Division S project has a 9% expected return. Since this project's return exceeds the division's WACC, the company should accept the project even though its return is less than the company's composite WACC. True or false? a. True b. False
false
Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC. True False
less than
Because the price of the security is lower when dealing with existing common stock than when dealing with newly issued shares, the cost of capital raised through retained earnings is GREATER THAN OR LESS THAN the cost of new common equity capital raised through the sale of new common stock. This is due to the flotation costs incurred with the sale of new common stock.
a
Because they are based on investors' required returns, the component costs of capital are market-determined variables. True False
•Yes, nonconstant growth stocks are expected to attain constant growth at some point, generally in 5 to 10 years. •May be complicated to calculate.
Can DCF methodology be applied if growth is not constant?
the return earned on assets depends on the (systematic) risk of those assets The return to an investor is the same as the cost to the company provides us with an indication of how the market views the risk of our assets, and how that risk is valued in our debt and equity on the other side of the balance sheet. Helps us determine our required return for capital budgeting projects
Explain 4 reasons why the weighted average cost of capital (WACC) is used in capital budgeting
•Firm's capital structure. •Firm's dividend policy. •The firm's investment policy. Firms with riskier projects generally have a higher WACC.
Factors the firm can control over WACC are..
Market conditions such as interest rates and tax rates.
Factors the firm cannot control over WACC are..
a
Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward. True False
r_S= D1/P0 +g
How do you calculate cost of common stock using DCF
rs = rRF + (rm - rRF)bi = rRF + (RPM)bi
How do you calculate the cost of commons stock using the CAPM approach?
rs = Long term bond yield + RP
How do you calculate the cost of commons stock using the bond yield plus risk premium approach?
greater than
If a firm cannot invest retained earnings to earn a rate of return GREATER THAN OR EQUAL TO.....the required rate of return on retained earnings, it should return those funds to its stockholders.
More risky; company not required to pay preferred dividend. However, firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.
Is preferred stock more or less risky to investors than debt?
e
Myers Corporation's stock currently trades at $40 a share. Investors estimate that the year-end dividend will be $2.00 a share and that its dividend will grow at 5% a year (i.e., D1 = $2.00 and g = 5%). The company needs to issue new stock in order to fund its upcoming projects, and investment bankers estimate that the flotation cost will be 4%. What is Myers' cost of new external equity? a. 11.3% b. 9.6% c. 8.5% d. 12.0% e. 10.2%
true
One definition of "capital" is funds supplied to a firm by investors. True False
capital components
One of the types of capital used by firms to raise funds. The investor-supplied items—debt, preferred stock, and common equity
12.43%
Pierce Enterprises's stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project the firm's growth rate to be constant at 7.27%. Using the cost of equity using the discounted cash flow (or dividend growth) approach, what is Pierce's cost of internal equity?
debt
Preferred stock is a hybrid security, because it has some characteristics typical of debt and others typical of equity. The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. Dividends are fixed.
equity
Preferred stock is a hybrid security, because it has some characteristics typical of debt and others typical of equity. The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. No tax adjustments are made when calculating the cost of preferred stock.
.29
Raymond Co. has $2.7 million of debt, $2.5 million of preferred stock, and $3.3 million of common equity. What would be its weight on preferred stock?
Stockholders focus on after-tax CFs. Therefore, we should focus on after-tax capital costs; i.e., use after-tax costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible.
Should our analysis focus on before-tax or after-tax capital costs?
The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today's marginal costs (for WACC).
Should our analysis focus on historical (embedded) costs or new (marginal) costs?
•NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the "hurdle rate" for a typical project with average risk. •Different projects have different risks. The project's WACC should be adjusted to reflect the project's risk.
Should the company use the composite WACC as the hurdle rate for each of its projects?
b
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the CAPM approach? a. 10.5% b. 10.3% c. 10.0% d. 8.8% e. 9.3%
a
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the DCF approach? a. 10.0% b. 10.3% c. 9.3% d. 8.8% e. 10.5%
b
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the bond-yield-plus-risk-premium approach? Use a 4% judgmental risk premium in your calculation. a. 9.3% b. 10.5% c. 8.8% d. 10.0% e. 10.3%
15.23%
The Jackson Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Jackson's bonds yield 10.28%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Jackson's cost of internal equity is:
average risk
The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of...
floatation cost
The amount that must be added to rs to account for flotation costs to find re.
false; it's NOT!!!
The cost of debt is also known as the coupon rate
a
The cost of depreciation-generated funds is approximately equal to the WACC calculated from retained earnings, preferred stock, and debt. True or false? a. True b. False
cost of new common stock
The cost of external equity; based on the cost of retained earnings, but increased for flotation costs necessary to issue new common stock.
9.15%
The current risk-free rate of return (rRFrRF) is 3.86% while the market risk premium is 5.75%. The D'Amico Company has a beta of 0.92. Using the capital asset pricing model (CAPM) approach, D'Amico's cost of equity is
before-tax cost of debt
The interest rate the firm must pay on new debt
true
The investor-supplied items—debt, preferred stock, and common equity—are called capital components. Increases in assets must be financed by increases in these capital components. True or false?
target capital structure
The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.
false
The optimal capital structure is the one where the percentages of debt, preferred stock, and common equity minimize the firm's value. True or false?
cost of preferred stock
The rate of return investors require on the firm's preferred stock; rp is calculated as the preferred dividend, Dp, divided by the current price, Pp.
cost of retained earnings
The rate of return required by stockholders on a firm's common stock.
after-tax cost of debt
The relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC.
cost of debt capital
The required rate of return on investment of the lenders of a company. - best estimated by calculating the yield to maturity on the existing debt
true
The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. True or false?
true
To calculate WACC, we can use individual costs of capital that we have computed to get our "average" cost of capital for the firm
1-T
To calculate the after-tax cost of debt, multiply the before-tax cost of debt by
true
To find the cost of perpetual preferred stock, divide the preferred's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. True False
false; Even though no direct costs are associated with retained earnings, there is still an opportunity cost associated with raising capital from retained earnings. A firm should earn at least as much on the investment of its retained earnings as the stockholders could earn on an alternative investment of equal risk, or the company should return those funds to the shareholders.
True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders.
Bond Yield plus Risk Premium Approach
Use the Risk Premium of stock over the firm's own bonds. Risk premium RP = 3-5% on average rs = Long term bond yield + RP
CAPM approach
Use the following information to compute our cost of equity: Risk-free rate, rRF Risk premium on the market, RPM = rm - rRF Systematic risk of asset, bi rs = rRF + (rm - rRF)bi = rRF + (RPM)bi
true
Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm's current operations If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project
7.77%
Water and Power Company (WPC) can borrow funds at an interest rate of 11.10% for a period of seven years. Its marginal federal-plus-state tax rate is 30%. WPC's after-tax cost of debt is
WACC
Weighted average cost of capital. The average cost of financing a firm in percentage terms.
a
Wellington Industries has two divisions, L and H. Division L is the company's low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company's high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division L is considering a project with an expected return of 9.5%. On what grounds do you base your accept-reject decision? Division L's project should be accepted, since its return is greater than the risk-based cost of capital for the division. Division L's project should be accepted, because its return is less than the risk-based cost of capital for the division.
accept
Wellington Industries has two divisions, L and H. Division L is the company's low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company's high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division L is considering a project with an expected return of 9.5%. Should Wellington Industries accept or reject the project? Reject the project Accept the project
CAPM DCF Bond yield + risk premium
What are 3 ways to determine the cost of equity?
Explicitly adjusts for systematic risk Applicable to all companies, as long as we can estimate beta
What are the advantages of using CAPM?
Easy to calculate Uses firm's own bond yield data
What are the advantages of using bond yield risk premium approach?
Advantage - easy to understand and use
What are the advantages of using the DCF approach?
Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are using the past to predict the future, which is not always reliable
What are the disadvantages of using CAPM?
Have to estimate the risk premium, which does vary over time Gives a ball park return for cost of equity
What are the disadvantages of using bond yield risk premium approach?
Only applicable to companies currently paying dividends Not applicable if dividends aren't growing at a reasonably constant rate Extremely sensitive to the estimated growth rate - an increase in g of 1% increases the cost of equity by 1% Does not explicitly consider risk
What are the disadvantages of using the DCF approach?
rd(1-t)
What is the formula for after-tax cost of debt?
debt - notes payable - long-term debt Preferred stock common equity - retained earnings - new common stock
What sources of capital do firms use?
cost of new common stock
When a firm issues new equity, there is a cost that must be paid to the investment bank (flotation costs)
e
Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Preferred stock. Long-term debt. Retained earnings. Common stock. Accounts payable.
a
Which of the following statements is NOT CORRECT? a. There are two ways to raise common equity. One source is retained earnings that involves bringing in new funds from outside the company, which represents external equity. The second source is new stock issues that involves bringing in new funds from current stockholders of the company, which represents internal equity. b. When new stock is issued, the company pays an investment bank to handle the expenses and fees involved with selling the stock. These expenses are called flotation costs. c. Flotation costs reduce the amount of capital the firm receives from a new stock issue. The company must make each dollar of the new issue work harder, so new investors earn their required rate of return. The new stock has a higher return (a higher cost), which is the stock's base "required rate of return" plus an adjustment for flotation costs. d. There are two ways to raise common equity. One source is retained earnings, which means that the firm has set aside some of its annual profits to reinvest in the firm instead of paying a dividend to stockholders. The second source is the issue of new stock, which involves selling stock to the public. e. The cost of retained earnings is less than the cost of new common stock due to flotation costs. While retained earnings may appear to be free money on the surface, there is an opportunity cost to them as these funds could be invested elsewhere and earning a return for shareholders. Due to the lower cost of retained earnings, companies generally prefer to use retained earnings to finance their projects, and only issue new common stock when they absolutely must.
•When a company issues new common stock they also have to pay flotation costs to the underwriter. •Issuing new common stock may send a negative signal to the capital markets, which may depress the stock price.
Why is the cost of retained earnings cheaper than the cost of issuing new common stock?
Corporations own most preferred stock, so 70% of preferred dividends are excluded from corporate taxation. The after-tax (AT) yield to an investor, and the AT cost to the issuer, are higher on preferred stock than on debt. Consistent with higher risk of preferred stock.
Why is the yield on preferred stock lower than debt?
•Earnings can be reinvested or paid out as dividends. •Investors could buy other securities, earn a return. •If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). •Investors could buy similar stocks and earn rs. •Firm could repurchase its own stock and earn rs.
Why is there a cost for retained earnings?
e
Wyatt Inc. uses the dividend-yield-plus-growth-rate approach to calculate the cost of equity. Investors expect Wyatt's year-end dividend (D1) to be $3.00 a share, its expected dividend growth rate is 5%, and the stock currently sells for $60 a share. What is Wyatt's cost of equity? a. 9.2% b. 7.4% c. 5.0% d. 8.5% e. 10.0%
cost of preferred stock
considered a perpetuity that is not growing. To calculate, use the formula for a non-growing perpetuity - dividend / price
weights
determined by how much of each type of financing we use
Weighted Average Cost of Capital (WACC)
expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings due to interest payments
D
market value of debt ( number of outstanding bonds X bond price )
V
market value of firm (debt + preferred stock + common stock)
Wc
percent financed with common stock is known as?
Wd
percent financed with debt is known as?
Wp
percent financed with preferred stock is known as?
E
represents market value of common stock ( number of outstanding shares x price per share )
p
represents market value of preferred stock (preferred stocks X price per share)
floatation costs
the costs incurred by the firm when it issues securities to raise funds can be incorporated either by adding them to the initial cost of a project at time 0 or by increasing the costof capital
rd
the symbol that represents the before-tax cost of debt in the weighted average cost of capital (WACC) equation.
rp
the symbol that represents the cost of preferred stock in the weighted average cost of capital (WACC) equation.
required return on assets
the weighted "average" is the ______________________, based on the market's perception of the risk of those assets
