Chapter 9 DSM

Duke Corporation is issuing $5 million in 30-year, 8% bonds, with bonds bearing a par value of $1,000. Flotation costs will be 3% of the par value. What is the net proceeds from the sale of each bond, assuming that the bonds sell at par?

$970 If the bonds sell at the par value $1,000 per bond, floatation costs will be 3% x $1,000 = $30 per bond, making the net proceeds $1,000 - $30 = $970.

A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources; Long-term debt = 45%, after-tax cost = 7% Preferred stock = 15%, after-tax cost = 10% Common stock equity = 40%, after-tax cost = 14% The weighted average cost of capital for this firm is;

10.25% A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources; Long-term debt = 45%, after-tax cost = 7% Preferred stock = 15%, after-tax cost = 10% Common stock equity = 40%, after-tax cost = 14% The weighted average cost of capital for this firm is 10.25%. To compute the cost you use the following formula: WACC = Wd(rd)(1-T) + Wps(rps) + Wce(rce) Where; Wd = weight of debt rd = cost of debt T = marginal tax rate Wps = weight of preferred stock rps = cost of preferred stock Wce = weight of common equity rce = cost of common equity Since this problem gives you the after-tax cost you will not need to adjust the cost of debt for taxes. So, WACC = (.45)(7%) + (.15)(10%) + (.40)(14%) = 3.15% + 1.5% + 5.6% = 10.25% The weights will all have to sum to 100% or 1.00.

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CAPM, what is the company's cost of equity?

10.5% The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and the market rate of return is 9%. Using the CAPM, the company's cost of equity is 10.5%. To compute the cost using CAPM you use the following model and inputs: rj = RF + {Bj x (rm - RF)] So, the cost of equity = 4% + [1.3 x (9% - 4%)] = 10.5%

A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________.

11.2% A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is 11.2%. Using the CAPM you can compute the cost of equity with the following formula; Cost of equity = risk-free rate + beta (market return - risk-free rate) So, the cost of equity = 4% + .90 (12% - 4%) = 11.2% The other method you can use to compute the cost of common equity is the constant-growth dividend model, which is also known as the Gordon growth model.

The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction's after-tax cost of debt is:

4.65% The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction's after-tax cost of debt is 4.65%. The YTM is the appropriate interest rate to use as the pre-tax debt cost since it is the rate that investors currently demand to hold Coastal's debt. However, since interest is tax deductible you need to multiply that rate by (1 - T), where T is the marginal tax rate, in order to get an after-tax cost of debt. So, Effective cost of debt = 6.2%(1 - .25) = 4.65%.

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the constant-growth valuation model, what is the company's cost of equity?

7.3% The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the constant-growth valuation model, the company's cost of equity is 7.3%. Cost of Equity = ($1.50/$45) + .04 = .073 or 7.3%

Corona Publishing has debt outstanding with a market value of $10 million. The company's common stock has a book value of $20 million and a market value of $30 million. What weight for equity should Corona use in its WACC calculation?

75% Corona Publishing has debt outstanding with a market value of $10 million. The company's common stock has a book value of $20 million and a market value of $30 million. Corona should use 75% as the weight for equity in its WACC calculation. You should always use market values to determine the total value of the firm and then compute the weights as a percentage of market value. In this case Corona's total value is $10 million debt + $30 million in equity = $40 million. Equity represents $30m/$40m, or 75% of that amount. Always be consistent and never mix market and book values in a single computation.

A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm's marginal tax rate is 40%. The cost of the preferred stock is;

8.25% A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3. The cost of the preferred stock is 8.25%. The cost of the preferred stock is equal to the preferred dividend divided by the proceeds received from the issue. Therefore, P0 = $8/($100 - $3) = $8/$97 = .08247 or 8.25% If the preferred stock is already outstanding you would use the current market price of the preferred stock as the denominator in the equation.

If Risky Corporation stock has a beta of 1.6, what is the required return, assuming a risk-free rate of 4% and a market rate of 7%?

8.8% According to the capital asset pricing model (CAPM), the required rate of return can be calculated as follows: r = RF + [B x (RM - RF)] where RF is the risk-free rate, RM is the market rate, and B is beta. If Risky Corporation stock has a beta of 1.6, the risk-free rate is 4%, and the market rate is 7%, then the required rate is: 4% + [1.6 (7% - 4%)] = 8.8%

The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.

9.57% The before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is 9.57%. The yield to maturity is the appropriate rate to use as the before-tax cost of a bond. The easiest way to compute the YTM is with a financial calculator using the following inputs; FV = $1,000; N = 20; PMT = $90; PV = -$950; CPT I/Y and you get 9.57%

The cost of common stock equity may be estimated by using the __________.

CAPM The cost of common stock equity may be estimated by using the CAPM. The capital asset pricing model is one of the methods you can use to compute the cost of equity based on the risk of the firm. Both the NPV and the IRR are capital budgeting project evaluation tools and are not related to any method of computing the cost of equity. The other method you can use to compute the cost of common equity is the Constant Dividend Growth Model (CDGM) which is also known as the Gordon Growth Model.

Which of the following inputs is needed when you use the constant-growth dividend model to estimate the cost of equity?

Current stock price The current stock price is needed when you use the constant-growth dividend model to estimate the cost of equity. As you can see in the constant-dividend growth model below you need to know the current stock price, the growth rate in dividends, and the expected dividend next period. rs = (D1/P0) + g The constant-dividend growth model is also known as the Gordon growth model.

Which of the following should be used as the firm's cost of debt?

The yield to maturity of the existing debt outstanding. The yield to maturity of the existing debt outstanding should be used as the firm's cost of debt. The YTM is the appropriate rate to use for cost of debt since this is the market determined rate that investors currently demand to hold your company's bonds. The coupon rate is irrelevant when determining cost of debt since it was set at the time of issue and may bear little resemblance to the current market rate of interest and the risk profile of the firm. The YTM captures all of those elements and represents the true cost of your firm's debt at this point in time. At any point in time the current risk-free rate of interest should be embedded or included in the current market rates.

The cost of retained earnings is equivalent to the cost of __________.

common stock The cost of retained earnings is equivalent to the cost of common stock. Retained earnings result from the firm reinvesting earnings instead of paying it out to shareholders in the form of a dividend. Shareholders expect the retained earnings to generate the same required return as their initial investment in the firm's stock. For this reason the cost of retained earnings is the same as the cost of common stock. The cost of preferred stock and debt are not related to the cost of retained earnings.

The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock.

cost of capital The cost of capital is the rate of return a firm must earn on its investment in order to maintain the market value of its stock. The cost of capital is the minimum rate that investors demand the firm earn on each new capital budgeting project. If a firm earns more than this it should increase the value of the firm and if it earns less than the cost of capital the value will fall, other things equal. The internal rate of return for a project is the rate that makes the net present value equal to zero. This rate does not establish a minimum required return but will instead be compared to the cost of capital. If the IRR exceeds the cost of capital the project is expected to generate returns sufficient to warrant investment. The coupon rate determines the amount of interest the company pays to service a specific bond issue. This rate has no bearing on the cost of capital other than its impact on the YTM. Keep in mind that you should use the Yield to Maturity (YTM) as the appropriate pre-tax interest rate on debt since it is the rate that investors demand to hold a specific bond.

The ______ represents the minimum rate of return that a project must earn to increase firm value.

cost of capital The cost of capital represents the firm's cost of financing and is the minimum rate of return that a project must earn to increase the firm's value. The cost of capital reflects the company's capital structure and the rates associated with various forms of debt and equity. Capital structure refers to the firm's mix of debt and equity.

The WACC represents the average __________ for the firm.

cost of financing The WACC represents the average cost of financing for the firm. The weighted average cost of capital contains the cost of both debt and equity financing so it represents an overall financing cost and not just a single component. A typical firm can have several different debt issues that each has a different YTM. When you compute the WACC you will have a separate cost and weight for each debt issue.

To use the CAPM to estimate the cost of equity you need to know the:

firm's beta To use the CAPM to estimate the cost of equity you need to know the firm's beta. The CAPM model is: E(Rj) = Rf + Bj(E(Rm) - Rf) where; E(Rj) = required return or expected return Rf = risk-free rate Bj = Beta of security j E(Rm) = expected return on the market Neither the firm's debt beta nor the prime rate of interest is an input in this model. You will need the expected return on the market, an beta, and the risk-free rate to use the CAPM to compute a cost of equity.

The total costs of issuing and selling a security are known as ______.

flotation costs Flotation costs represent the total costs of issuing and selling securities. These costs apply to all public offerings of securities: debt, preferred stock, and common stock. Flotation costs include two components: (1) underwriting costs, or compensation earned by investment banks for selling the security; and (2) administrative costs, or issuer expenses such as legal and accounting costs.

The effective cost of debt is:

less than the return paid to debt holders due to tax benefits of interest paid The effective cost of debt is less than the return paid to debt holders due to tax benefits of interest paid. Since interest paid can be expensed it reduces a firm's overall tax liability and therefore the overall cost of debt. A quick way to determine the effective cost of debt is to multiply the cost of debt by (1 minus the marginal tax rate). And, the coupon rate is not the appropriate rate to use as the before-tax cost of debt. The yield to maturity is the appropriate cost since it is the actual rate that current investors demand to hold your firm's debt.

A tax adjustment must be made in determining the cost of:

long-term debt A tax adjustment must be made in determining the cost of long-term debt. Since interest payments on long-term debt can be expensed they reduce the firm's tax liability and lower the effective cost of long-term debt. There is no such tax benefit from dividends paid so there is no tax adjustment for any equity account such as common stock or retained earnings.

The cost of new preferred stock in the WACC is computed as the preferred dividend divided by the __________.

net proceeds from the sale of the preferred. The cost of new preferred stock in the WACC is computed as the preferred dividend divided by the net proceeds from the sale of the preferred. Using this method reduces the preferred by the amount of any flotation costs since the firm does not get to utilize that component of the sale proceeds. The par value is used to determine the fixed dividend paid by the firm and does not impact cost of capital. The market value of the firm's common stock is not used in computing the cost of preferred stock.

The cost of debt used in the WACC is adjusted lower __________.

since there is a tax shield associated with paying interest The cost of debt used in the WACC is adjusted lower since there is a tax shield associated with paying interest. The Internal Revenue Code allows interest to be expensed and therefore it creates a tax shield when firms use debt. This effectively lowers the cost of debt to the firm. Dividends are paid with after-tax dollars and interest is expensed so it comes out pre-tax and lowers the firm's tax burden and therefore lowers the cost of debt.

The firm's optimal mix of debt and equity is called its:

target capital structure The firm's optimal mix of debt and equity is called its target capital structure. The optimal mix of debt and equity is the one where the firm's cost of capital is the lowest. At this point the value of the firm is maximized. Once a financial manager identifies this mix the firm will use this as a target in order to maximize share price. The debt-to-equity ratio tells you the current mix of debt and equity which may or may not be the target mix. The required reserve ratio deals with bank reserves and not a firm's capital structure.

When we use the WACC as the discount rate in capital budgeting, we are assuming:

the firm will maintain a constant debt-to-equity ratio. When we use the WACC as the discount rate in capital budgeting, we are assuming the firm will maintain a constant debt-to-equity ratio. Since most capital budgeting projects last for several years you have to use a discount rate that will reflect the cost of capital over a similar time horizon. When you use WACC you are implying that you expect the WACC to be relatively stable over that time period. And, since the weights of debt relative to equity can have a significant impact on WACC, you are also making the assumption that those weights will remain the same. Interest expenses will increase as you increase debt so the tax shield will also go up. And, if the project has a higher risk than the overall firm you would make an adjustment by increasing the discount rate above WACC, or by reducing the project's expected cash flows.