504 Ch. 12 - Cost of Capital

Titans has 7 percent bonds outstanding that mature in 16 years. The bonds pay interest semiannually and have a face value of $1,000. Currently, the bonds are selling for $1,015 each. What is the firm's pretax cost of debt? A. 6.97 percent B. 6.84 percent C. 7.14 percent D. 7.31 percent E. 6.40 percent

B. 6.84 percent $1,015 = [(.07 ×$1,000) / 2] ×({1 - 1 / [1 + (RD / 2)]32} / (RD / 2)) + $1,000 / [1 + (RD / 2)]32 RD = 6.84 percent

Madison Square Stores has a $20 million bond issue outstanding that currently has a market value of $19.4 million. The bonds mature in 6.5 years and pay semiannual interest payments of $35 each. What is the firm's pretax cost of debt? A. 8.21 percent B. 7.59 percent C. 7.08 percent D. 7.74 percent E. 7.80 percent

B. 7.59 percent Current bond price = (19.4 /20) ×$1,000 = $970 $970 = $35 ×({1 - 1 / [1 + (RD / 2)]13} / (RD / 2))+ $1,000 / [1 + (RD / 2)]13 RD = 7.59 percent

A firm has a cost of equity of 13 percent, a cost of preferred of 11 percent, an after-tax cost of debt of 5.2 percent, and a tax rate of 35 percent. Given this, which one of the following will increase the firm's weighted average cost of capital? A. Increasing the firm's tax rate B. Issuing new bonds at par C. Redeeming shares of common stock D. Increasing the firm's beta E. Increasing the debt-equity ratio

D. Increasing the firm's beta

Which statement is correct, all else held constant? A. Beta is used to compute the return on equity and the standard deviation is used to compute the return on preferred. B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options. C. The after-tax cost of debt increases when the market price of a bond increases. D. If you have both the dividend growth and the security market line's costs of equity, you should use the higher of the two estimates when computing WACC. E. WACC is applicable only to firms that issue both common and preferred stock.

B. A decrease in a firm's WACC will increase the attractiveness of the firm's investment options.

The weighted average cost of capital is defined as the weighted average of a firm's: A. return on all of its investments. B. cost of equity, cost of preferred, and its after-tax cost of debt. C. pretax cost of debt and its preferred and common equity securities. D. bond coupon rates. E. common and preferred stock.

B. cost of equity, cost of preferred, and its after-tax cost of debt.

Gulf Coast Tours currently has a weighted average cost of capital of 12.4 percent based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is .47 and the aftertax cost of debt is 6.1 percent. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm? A. 15.45 percent B. 12.92 percent C. 12.89 percent D. 13.37 percent E. 15.36 percent

E. 15.36 percent WACC = .124 = (1/1.47)(x) + (.47 /1.47)(.061) x = 15.36 percent

The 6.5 percent preferred stock of Home Town Brewers is selling for $42 a share. What is the firm's cost of preferred stock if the tax rate is 35 percent and the par value per share is $100? A. 17.50 percent B. 15.92 percent C. 16.17 percent D. 16.52 percent E. 15.48 percent

E. 15.48 percent Rp = (.065 ×$100)/$42 = .1548, or 15.48 percent

Country Cook's cost of equity is 16.2 percent and its after-tax cost of debt is 5.8 percent. What is the firm's weighted average cost of capital if its debt-equity ratio is .42 and the tax rate is 34 percent? A. 12.54 percent B. 11.47 percent C. 13.12 percent D. 12.28 percent E. 13.01 percent

C. 13.12 percent WACC = (1/1.42)(.162) + [(.42 /1.42)(.058)] = .1312, or 13.12 percent

The common stock of Contemporary Interiors has a beta of 1.13 and a standard deviation of 21.4 percent. The market rate of return is 12.7 percent and the risk-free rate is 4.1 percent. What is the cost of equity for this firm? A. 13.82 percent B. 11.76 percent C. 12.08 percent D. 14.40 percent E. 13.05 percent

A. 13.82 percent RE= .041 + 1.13 ×(.127-.041) = .1382, or 13.82 percent

Western Electric has 21,000 shares of common stock outstanding at a price per share of $61 and a rate of return of 15.6 percent. The firm has 11,000 shares of $8 preferred stock outstanding at a price of $48 a share. The outstanding debt has a total face value of $275,000 and currently sells for 104 percent of face. The yield to maturity on the debt is 8.81 percent. What is the firm's weighted average cost of capital if the tax rate is 35 percent? A. 14.52 percent B. 13.44 percent C. 14.19 percent D. 14.37 percent E. 13.92 percent

A. 14.52 percent Common stock: 21,000 × $61 = $1,281,000 Preferred stock: 11,000 × $48 = $528,000 Debt: 1.04 × $275,000 = $286,000 Value = $1,281,000 + 528,000 + 286,000 = $2,095,000 WACC = ($1,281,000/$2,095,000)(.156) + ($528,000/$2,095,000)($8/$48) + ($286,000/$2,095,000)(.0881)(1 -.35) = .1452, or 14.52 percent

USA Manufacturing issued 30-year, 7.5 percent semiannual bonds 6 years ago. The bonds currently sell at 101 percent of face value. What is the firm's after-tax cost of debt if the tax rate is 35 percent? A. 4.82 percent B. 5.62 percent C. 3.76 percent D. 3.59 percent E. 4.40 percent

A. 4.82 percent $1,010 = [(.075 × $1,000) / 2] ×({1 - 1 / [1 + (RD / 2)]48} / (RD / 2))+ $1,000 / [1 + (RD/ 2)]48 RD = 7.4102 percent After-tax cost of debt = 7.4102 percent ×(1 -.35) = 4.82 percent

The Color Box uses a combination of common stock, preferred stock, and debt financing. The company wants preferred stock to represent 7 percent of the total financing. It also wants to structure the firm in a manner that will produce a weighted average cost of capital of 9.5 percent. The after-tax cost of debt is 4.8 percent, the cost of preferred is 8.9 percent, and the cost of common stock is 14.7 percent. What percentage of the firm's capital funding should be debt financing? A. 48.42 percent B. 52.03 percent C. 54.15 percent D. 44.78 percent E. 39.21 percent

A. 48.42 percent .095 = (1 -.07 -x)(.147) + (.07)(.089) + (x)(.048) x = 48.42 percent

Santa Claus Enterprises has 87,000 shares of common stock outstanding at a current price of $39 a share. The firm also has two bond issues outstanding. The first bond issue has a total face value of $230,000, pays 7.1 percent interest annually, and currently sells for 103.1 percent of face value. The second bond issue consists of 5,000 bonds that are selling for $887 each. These bonds pay 6.5 percent interest annually and mature in eight years. The tax rate is 35 percent. What is the capital structure weight of the firm's debt? A. 57.93 percent B. 51.39 percent C. 55.50 percent D. 60.52 percent E. 71.86 percent

A. 57.93 percent Common stock = 87,000 × $39 = $3,393,000 Debt = (1.031 ×$230,000) + (5,000 × $887) = $4,672,130 Weight of debt = $4,672,130/($3,393,000 + 4,672,130) = .5793, or 57.93 percent

udy's Boutique just paid an annual dividend of $1.48 on its common stock and increases its dividend by 2.2 percent annually. What is the rate of return on this stock if the current stock price is $29.60 a share? A. 7.31 percent B. 8.37 percent C. 7.54 percent D. 8.19 percent E. 8.33 percent

A. 7.31 percent Re = [($1.48× 1.022) / $29.60] + .022 = .0731, or 7.31 percent

Bob's is a retail chain of specialty hardware stores. The firm has 18,000 shares of stock outstanding that are currently valued at $82 a share and provide a rate of return of 13.2 percent. The firm also has 600 bonds outstanding that have a face value of $1,000, a market price of $1,032, and a coupon rate of 7 percent. These bonds mature in 7 years and pay interest semiannually. The tax rate is 35percent. The firm is considering expanding by building a new superstore. The superstore will require an initial investment of $9.3 million and is expected to produce cash inflows of $1.07 million annually over its 10-year life. The risks associated with the superstore are comparable to the risks of the firm's current operations. The initial investment will be depreciated on a straight line basis to a zero book value over the life of the project. At the end of the 10 years, the firm expects to sell the superstore for an aftertax value of $4.7 million. Should the firm accept or reject the superstore project and why? A. Accept; The project's NPV is $1.27 million. B. Accept; The NPV is $4.89 million. C. Reject; The NPV is $1.06 million. D. Reject; The NPV -$1.15 million. E. Reject; The NPV is -$5.71 million.

D. Reject; The NPV -$1.15 million. Stock: 18,000 × $82 = $1,476,000 Bonds: 600 × $1,032 = $619,200 Value = $1,476,000 + 619,200 = $2,095,200 $1,032 = [(.07 × $1,000) / 2]× ({1 / [1 + (r/ 2)]14} / (r / 2)) + $1,000 / [1 + (r / 2)]14 r = 6.43 percent WACC = ($1,476,000/$2,095,200)(.132) + ($619,200 /$2,095,200)(.0643)(1 - .35) = .1053, or 10.53 percent NPV = -$9.3m + $1.07m(PVIFA10, 10.53%) + $4.7m/1.105310 = -$1.15 million The project should be rejected because the NPV is negative at the firm's cost of capital.