Finance 3220 Chapter 10
Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?
0.37%
Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising?
10.40%
Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?
10.44%
O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?
11.30%
You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?
11.33%
Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re?
11.50%
Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)?
11.77%
A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?
12.60%
Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?
13.37%
Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of retained earnings, rs?
14%
To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?
5.08%
Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate?
7.40%
Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC?
9.08%
weighted average cost of capital, WACC
A weighted average of the component costs of debt, preferred stock, and common equity.
Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Accounts payable.
Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely:
Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.
Which of the following statements could be true concerning the costs of debt and equity?
Either the cost of debt for Firm A is greater than the cost of equity for Firm B or the cost of retained earnings for Firm A is less than its cost of new outside equity could be true statements.
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.
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.
False
If the debt ratio is 50%, the interest rate on new debt is 8%, the tax rate is 40%, and the current cost of equity is 16%, then an increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).
False
Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock?
Increase the percentage of debt in the target capital structure.
capital components
One of the types of capital used by firms to raise funds.
The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project.
retained earnings breakpoint
The amount of capital raised beyond which new common stock must be issued.
flotation cost
The amount that must be added to rs to account for flotation costs to find re.
flotation cost adjustment
The amount that must be added to rs to account for flotation costs to find re.
Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted?
The company will take on too many high-risk projects and reject too many low-risk projects.
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.
Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.
before-tax cost of debt, rd
The interest rate the firm must pay on new debt.
target capital structure
The mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects.
cost of preferred stock, rp
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, rd(1-T)
The relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC.
Which of the following statements is NOT CORRECT?
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.
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
Because they are based on investors' required returns, the component costs of capital are market-determined variables.
True
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
In capital budgeting, the cost of capital should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.
True
One definition of "capital" is funds supplied to a firm by investors.
True
Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.
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
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)
Yes; the expected return is 2.5 percentage points higher than the cost of capital.
Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure.
re > rs > WACC > rd.
