fin ch 14 Chapter 14: Cost of Capital, CH14 Cost of Capital, Ch 14: Cost of Capital

Preferred stock pays..

*dividends in perpetuity *a constant dividend

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 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

What can we say about the dividends paid to common stock and preferred stock holders?

1. Dividends to common stockholders are not fixed 2. Dividends to preferred stock holders are fixed

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

1. cost of common stock 2. cost of debt 3. cost of preferred stock

Dang's Donut has EBIT of $25,432 depreciation $1,500, and a tax rate of 18%. The company will not be changing it's net working capital, but plans a capital expenditure of $6,324. What is Dant's adjusted cash flow from assets?

16030.24

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 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.

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

Sigma corporation consists of 2 divisions A and B. A is riskier than B. If Sigma Corp uses the firm's overall WACC to evaluate both divisions projects, which division will probably not receive all of its potentially profitable projects?

Division B

The market risk premium is defined as

Rm-Rf

14.2b What are the two approaches to estimating the cost of equity capital?

The dividend growth model approach and the SML approach.

14.5a What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?

The likely consequences include accepting projects with more risk than the overall firm and rejected projects with less risk than the firm.

14.1a What is the primary determinant of the cost of capital for an investment?

The use of the funds.

14.2a What do we mean when we say that a corporation's cost of equity capital is 16 percent?

This means that the required return for investors in the firm is 16 percent.

14.6b Why do you think we might prefer to use a ratio when calculating the terminal value when we do a firm valuation?

Using a ratio allows for the comparison of different firm valuations.

What does WACC stand for?

Weighted average cost of capital

If a firm has multiple projects, each project should be discounted using _____

a discount rate commensurate with the project's risk

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

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

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

equal to

If the firm is all equity, the discount rate is equal to the firms cost of ______ capital

equity

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

flotation

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

Finding a firm's overall cost of equity is difficult to calculate 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 equity's 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

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.

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

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

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.

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

the rate used to discount project cash flows is known as the _____

1. required return 2. cost of capital 3. discount rate

To calculate the firm's equity cost of capital using the CAPM, we need to know the _____.

1. risk free rate 2. market risk premium 3. beta

the WACC is the minimum return a company needs to earn to satisfy _______

1. the bondholders 2. the stakeholders

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

1. use security analysts forecasts 2. use the historical dividend growth rate

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%

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

14.7a What are flotation costs?

Flotation costs are the costs incurred when a firm issues new stocks or bonds to finance projects.

14.4b Why do we multiply the cost of debt by (1-Tc) when we compute the WACC?

Interest paid to bondholders is tax deductible. We multiply the cost of debt by (1-Tc) to factor in the portion of the interest that the government pays. This is the post-tax cost of debt.

The pre-tax cost of debt

Is based on the current yield to maturity of the firm's outstanding bonds

14.4c Under what conditions is it correct to use the WACC to determine NPV?

It is correct to use the WACC to determine NPV is the proposed investment is a replica of the firm's existing operations or if the investment is closely related to the firm's operations.

14.3b How can the cost of debt be calculated?

The cost of debt can be calculated by observing the current interest rate the firm must pay on new borrowing or the interest rate on similarly rated bonds.

14.3c How can the cost of preferred stock be calculated?

The cost of preferred stock is the dividend yield on the preferred stock. It can also be determined by observing the required returns on similarly rated preferred stock.

14.3a Why is the coupon rate a bad estimate of a firm's cost of debt?

The coupon rate measures what the firm's initial cost of debt. It does not estimate the current cost or yield.

14.5b What is the pure play approach to determining the appropriate discount rate? When might it be used?

The pure play approach uses a WACC that is unique to a project based on other companies in similar lines of business. It might be used when a company is looking into a project outside of its current operations (a new line of business) and is estimating the required return of the new investment.

14.1b What is the relationship between the required return on an investment and the cost of capital associated with that investment?

The required return and the cost of capital are essentially the same. The required return is what the firm must earn to compensate the investors for their use of capital required to finance the project.

According to the CAPM, what is the expected return on a stock if its beta is equal to zero?

The risk-free rate

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

being created or destroyed

Method for calculating the cost of equity ignores risk

the dividend growth model

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

the dividend growth model

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

the investors

ULC and LEV have earnings before interest and taxes of $110. LEV has $20 of interest expense. Both companies are taxed at 30%, ULC aftertax earnings are ___, which is ______ than LEV's aftertax earnings.

$77; $14 greater

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

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

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

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

*discount rate *required return *cost of capital

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

The SML approach requires estimates of

1. market risk premium 2. beta coefficient

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.

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%

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%

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%

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%

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)

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%

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%

The market risk premium is defined as

R∨M - R∨f

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%

14.4a How is the WACC calculated?

The WACC is calculated by adding the products of the cost of equity by its capital structure weight and the cost of debt by its capital structure weight. If the firm is financed by preferred stock, then the product of the cost of preferred stock and its capital structure weight must be added to the equation. WACC = (E/V) * Re + (D/V) * Rd (1-Tc)

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

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%

14.6a Why do we adjust a firm's taxes when we do a firm valuation?

We adjust the taxes to removed the effects of debt financing. Debt financing causes a reduction in taxes due to interest paid which is tax deductible.

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

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)

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

the investors who supply capital. *its stockholders and its bondholders

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

The cost of preferred stock is computed the same as the:

Rate of return on a perpetuity.

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

Re= D1/P0 + g

14.7b How are flotation costs included in an NPV analysis?

The true cost of funding the new plant [x/(1-fa)] is deducted from the project's PV of cash flows giving the true NPV of the project.

will increase a firm's aftertax cost of debt

a Decrease in the firm's tax rate.

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