Chapter 11: Cost of Capital
target capital structure
A firm's shareholder wealth-maximizing combination of debt, and common and preferred stock.
investment opportunity schedule
A table or graph of a firm's potential investments listed in decreasing order of their internal rates of return.
investment opportunity schedule
A table or graph of a firm's potential investments ranked from the highest internal rate of return to the lowest.
A firm will increase in value if it invests in projects based on a WACC that is lower than the investors' required rate of return.
False
The amount that an investor is willing to pay for a firm's bonds is inversely related to the firm's cost of preferred stock.
False
________ is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of capital (WACC) equation.
Re
breakpoint
The amount of capital expenditures made, or to be made, at which the firm's marginal cost of capital increases.
Weighted Average Cost of Capital (WACC)
The average cost of a firm's financial capital when averaged across all of its outstanding debt and equity capital.
marginal cost of capital
The average cost of the next dollar of financial capital raised by a firm.
Weighted Average Cost of Capital (WACC)
The average rate paid by a firm to secure the outstanding financial capital used to acquire the firm's assets.
capital components
The elements in a firm's capital structure.
cost of capital
The minimum return that must be earned on a firm's investments to ensure that the firm's value does not decrease.
breakpoint
The point along the firm's marginal cost of capital (MCC) curve or schedule at which the MCC increases.
Cost of Debt
The return required by providers of capital loaned to the firm.
Flotation costs increase the cost of newly issued stock compared to the cost of the firm's existing, or already outstanding, common stock or retained earnings.
True
The amount that an investor is willing to pay for a firm's bonds is inversely related to the firm's cost of debt without considering the cost of issuing the bonds.
True
The amount that an investor is willing to pay for a firm's preferred stock is inversely related to the firm's cost of preferred stock before flotation costs.
True
The cost of retained earnings is the same as the cost of internal (common) equity.
True
The difference between the cost of retained earnings and the cost of new common equity is the cost to issue the new common stock. also known as the flotation costs
True
The firm's cost of debt is what an investor is willing to pay for the firm's bonds before considering the cost of issuing the debt.
True
true or false: The amount that an investor is willing to pay for a firm's stock is inversely related to the firm's cost of common equity before flotation costs.
True
Does the cost of capital schedule below match the MCC schedule depicted on the graph? Yes No
Yes
The _________ is the interest rate that a firm pays on any new debt financing.
before-tax cost of debt
A firm will never have to take flotation costs into account when calculating the cost of raising capital from ________
retained earnings
The firm's cost of debt is what an investor is willing to pay for the firm's stock before considering flotation costs.
False
True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. The cost of issuing new common stock is calculated the same way as the cost of raising equity capital from retained earnings. False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings. True: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of retained earnings is based on the firm's existing common equity, while the cost of new common stock is based on the value of the firm's share price net of its flotation cost.
False: Flotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings.
target capital structure
The combination of debt, preferred stock, and common equity that will maximize the value of the firm's common stock.
cost of debt
The cost associated with a firm's borrowed financial capital.
flotation costs
The costs associated with issuing new financial securities.
cost of capital
The return that providers of financial capital require to induce them to provide capital to a firm, and the associated cost to the firm for securing these funds.
marginal cost of capital
The weighted average cost of the last dollar raised by a firm, or the firm's incremental cost of capital.
flotation costs
These costs are generally expressed as a percentage of the total amount of securities sold, including the costs of printing the security certificates, applicable taxes, and issuance and marketing fees.
opportunity cost principle
This concept argues that a firm's retained earnings are not free to the firm.
opportunity cost principle
This concept maintains that the firm's retained earnings should generate a return for the firm's shareholders.
capital components
This term refers to the individual sources of the firm's financing, including its debt, preferred stock, retained earnings, and newly issued common equity.
A firm will lose wealth if it invests in projects based on a WACC that is lower than the investors' required rate of return.
True
A firm's cost of capital is determined by the investors who purchase the firm's stocks and bonds.
True
If a firm cannot invest retained earnings to earn a rate of return _________________ the required rate of return on retained earnings, it should return those funds to its stockholders.
greater than or equal to
