Keen Chapter 11
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%. Cost of equity = risk-free rate + beta(market return - risk-free rate) So, the cost of equity = 4% + .90(12% - 4%) = 11.2%
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% Rps = $8/($100 - $3) = $8/$97 = .08247 or 8.25%
Select the order in which the indicated WACCs would apply to an average-risk, a high-risk, and a low-risk project, respectively.
As Per the Risk and Return Theoryan investment with more risk will have more return 10% for average, 12% for High, 8% for low
When calculating the after-tax weighted average cost of capital (WACC), which of the following costs is adjusted for taxes in the equation?
Before -Tax cost of debt
The cost of an asset carried on the balance sheet is known as:
Book Value
The ________ of an asset or liability is its cost carried on the balance sheet.
Book Value
The cost of common stock equity may be estimated by using the __________.
CAPM
Assume the following: The risk-free rate is 2%, the expected return on the market is 7%, and this firm's stock is twice as risky as the market on average. What would be the cost of equity for this firm?
Cost of equity= Risk-Free Rate + Beta(Market Return - Risk Free Rate)
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 dividend growth model, what is the company's cost of equity?
Cost of equity= (1.50/45)+.04
Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?
Current stock price Cost of Equity = (Div1/Pe)+g
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?
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 So, Cost of equity = 4% + 1.3(5%) = 10.5%
The after-tax cost of debt is higher than the before-tax cost of debt.
False the tax effect on the interest is not disadvantage. Since interest is paid on the debt, interest is an expense and thus there is tax shield.
The cost of capital uses the amounts of total assets and debt as the capital structure weights.
False It uses the weights of debt and equity to calculate the WACC.
projects with lower than average risk should be evaluated using a higher than average WACC.
False. Must be evaluated using a lower than the average WACC.
A tax adjustment must be made in determining the cost of:
Long-term deb
A company with a tax rate of 35% borrows $150M from Lender A at a cost of 9% and $350M from Lender B at a cost of 12%. What is the firm's aggregate cost of borrowing (a) before; and (b) after taxes?
NOTES
Assume the current stock price is $40 per share, next year's dividend is expected to be $2.00 and dividends are expected to grow at 4% per year from here on out. What would be the cost of equity for this firm?
NOTES
Investors ________ for estimating the WACC.
Prefer Market Value to Book Value
The cost of capital is also known as the "hurdle rate".
TRUE Reason: Cost of capital is the minimum rate of return required on the investment and hence also known as the hurdle rate.
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 effective cost of debt is:
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%.
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;
The cost of the preferred stock is equal to the preferred dividend divided by the proceeds received from the issue. Therefore, Rps = $8/($100 - $3) = $8/$97 = .08247 or 8.25%
The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.
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%
Which of the following should be used as the firm's cost of debt?
The yield to maturity of the existing debt outstanding.
Bartleman Industries is raising $5 million through the sale of $100 par value preferred stock that pays a 5% dividend. If flotation costs are $2 a share how much is the percentage cost of the preferred stock?
To compute the cost you divide the dividend by the net price received for the preferred. issue pays a dividend equal to 5% of the par value which is a $5 dividend. The cost is therefore $5/($100 - $2 flotation cost) or $5/$98 = .051 or 5.1%.
You borrow the following from your friends: $1,400 from John and $600 from Mary. John charges you 5% and Mary charges you 10%. What is your combined before-tax cost of borrowing from your friends?
Total Capital value = Value of John + Value of Mary =1400+600=2000 Weight of John = Value of John/Total Capital Value = 1400/2000=0.7 Weight of Mary = Value of Mary/Total Capital Value = 600/2000=0.3 Cost of Capital = Weight of John*Cost of John+Weight of Mary*Cost of Mary Cost of Capital = 5*0.7+10*0.3 Cost of Capital = 6.5
An unlevered firm is an all-equity firm.
True
In deriving the WACC, market values are preferred over book values for the capital structure weights.
True
The constant dividend growth model and CAPM are two ways of estimating a firm's cost of equity.
True
When estimating the cost of debt financing from bonds, a firm can use the yield-to-maturity as the before-tax cost of debt.
True
a lower tax rate would result in a higher WACC.
True
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;
WACC = Wd(kd)(1-T) + Wps(kps) + Wce(kce) Where; Wd = weight of debt kd = cost of debt T = marginal tax rate Wps = weight of preferred stock kps = cost of preferred stock Wce = weight of common equity kce = 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 appropriate discount rate to use when evaluating capital budgeting projects using NPV is the:
WACC.
A company has outstanding debt with a market value of $250M and common stock with a market value of $550M. If its debt has a before-tax cost of 7%, a before-tax cost of equity of 10% and a corporate tax rate of 40%, what is its WACC?
Weight of Equity = (Equity Value) / (Equity Value + Debt Value) Weigh of Debt = (Debt Value)/(Equity Value + Debt Value) WACC = (Weight of Equity X Cost Of Equity) + (Weight of Debt X Cost Of Debt X ( 1 - Tax Rate))
Alloy Supply Co. has a new project that will require the company to borrow $3,000,000. Acme has made an agreement with three lenders for the needed financing. First National Bank will give $1,500,000 and wants 6% interest on the loan. Banner Bank will give $1,000,000 and wants 9% interest on the loan. Western National Bank will give $500,000 and wants 7% interest on the loan. What is the weighted average cost of capital to acquire the $3,000,000?
Weight of F = (Loan From F) / (Loan from F + Loan From B + Loan From W) Weight of B = (Loan From B) / (Loan from F + Loan From B + Loan From W) Weight of W = (Loan From W) / (Loan from F + Loan From B + Loan From W) WACC = (Weight of F + Interest of F) + (Weight of B + Interest of B) +(Weight of W + Interest of W)
Eric has another get-rich-quick idea, but needs funding to support it. He chooses an all-debt funding scenario. He will borrow $3970 from Wendy, who will charge him 5% on the loan. He will also borrow $2,926 from Bebe, who will charge him 87% on the loan. He will borrow $1104 from Shelly, who will charge him 143% on the loan. What is the weighted average cost of capital for Eric?
Weighted average cost of capital = Sum of [Cost of debt x Weight of debt] [5% x 3970 / (3970+2926+1104)] + [7% x 2926 / (3970+2926+1104)] + [13% x 1104 / (3970+2926+1104)] = 6.8355%
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?
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.
To compute the after-tax cost of debt you need to multiply the cost of debt by:
a factor equal to one minus the marginal tax rate, or (1 - marginal tax rate).
The specific cost of each source of long-term financing is based on __________ costs.
after-tax and current
A firm's __________ refers to the mix of debt and equity used for financing its assets and operations.
capital structure
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 WACC represents the average __________ for the firm.
cost of financing
To use the CAPM to estimate the cost of equity you need to know the:
firm's beta.
Since preferred stock dividends are fixed in the same manner of a coupon bond's interest payment it is referred to as:
hybrid equity.
The effective cost of debt is:
less than the return paid to debt holders due to tax benefits of interest paid
One way to adjust for projects with different levels of risk is to compute the NPV using a WACC computed with a:
project-specific beta.
The cost of capital is ________.
the cost of each financing component multiplied by that component's percent of the total borrowed
The pure play method of assigning project-based betas involves:
using the beta of a firm in a similar line of business.