CFA 36: Cost of Capital
Wang Securities had a long-term stable debt-to-equity ratio of 0.65. Recent bank borrowing for expansion into South America raised the ratio to 0.75. The increased leverage has what effect on the asset beta and equity beta of the company? The asset beta and the equity beta will both rise. The asset beta will remain the same and the equity beta will rise. The asset beta will remain the same and the equity beta will decline.
B is correct. Asset risk does not change with a higher debt-to-equity ratio. Equity risk rises with higher debt.
Which of the following statements is correct? The appropriate tax rate to use in the adjustment of the before-tax cost of debt to determine the after-tax cost of debt is the average tax rate because interest is deductible against the company's entire taxable income. For a given company, the after-tax cost of debt is generally less than both the cost of preferred equity and the cost of common equity. For a given company, the investment opportunity schedule is upward sloping because as a company invests more in capital projects, the returns from investing increase.
B is correct. Debt is generally less costly than preferred or common stock. The cost of debt is further reduced if interest expense is tax deductible.
Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a US-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable "pure-play" companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in recent years. Company Sales in Millions ($) Market Value Equity in Millions ($) Market Value Debt in Millions ($) Equity Beta Tax Rate Share Price ($) Relevant Ltd. 752 3,800 0.0 1.702 23 percent 42 ABJ, Inc. 843 2,150 6.5 2.800 23 percent 24 Opus Software Pvt. Ltd. 211 972 13.0 3.400 23 percent 13 Duarte uses the information from the preliminary prospectus for TagOn's initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists of a $2.4 million five-year non-callable bond issue and 1 million common shares. Other information that Duarte has gathered: Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent, with a market value of $2.156 million Risk-free rate of interest 5.25 percent Estimated equity risk premium 7 percent Tax rate 23 percent The marginal cost of capital for TagOn, based on an average asset beta of 2.27 for the industry and assuming that new stock can be issued at $8 per share, is closest to: 20.5 percent. 21.0 percent. 21.5 percent.
C is correct. For debt: FV = 2,400,000; PV = 2,156,000; n = 10; PMT = 150,000 Solve for i. i = 0.07748. YTM = 15.5% Before-tax cost of debt = 15.5% Market value of equity = 1 million shares outstanding + 1 million newly issued shares = 2 million shares at $8 = $16 million Total market capitalization = $2.156 million + $16 million = $18.156 million Levered beta = 2.27 {1 + [(1 − 0.23)(2.156/16)]} = 2.27 (1.1038) = 2.5055 Cost of equity = 0.0525 + 2.5055 (0.07) = 0.2279 or 22.79% Debt weight = $2.156/$18.156 = 0.1187 Equity weight = $16/$18.156 = 0.8813 TagOn's MCC = [(0.1187)(0.155)(1 − 0.23)] + [(0.8813)(0.2279)] = 0.01417 + 0.20083 = 0.2150 or 21.50%
Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a US-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable "pure-play" companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in recent years. Company Sales in Millions ($) Market Value Equity in Millions ($) Market Value Debt in Millions ($) Equity Beta Tax Rate Share Price ($) Relevant Ltd. 752 3,800 0.0 1.702 23 percent 42 ABJ, Inc. 843 2,150 6.5 2.800 23 percent 24 Opus Software Pvt. Ltd. 211 972 13.0 3.400 23 percent 13 Duarte uses the information from the preliminary prospectus for TagOn's initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists of a $2.4 million five-year non-callable bond issue and 1 million common shares. Other information that Duarte has gathered: Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent, with a market value of $2.156 million Risk-free rate of interest 5.25 percent Estimated equity risk premium 7 percent Tax rate 23 percent Using the capital asset pricing model, the cost of equity capital for a company in this industry with a debt-to-equity ratio of 0.01, asset beta of 2.27, and a marginal tax rate of 23 percent is closest to: 17 percent. 21 percent. 24 percent.
B is correct. Asset beta = 2.27 Levered beta = 2.27 {1 + [(1 − 0.23)(0.01)]} = 2.2875 Cost of equity capital = 0.0525 + (2.2875)(0.07) = 0.2126 or 21.26%
Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a US-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable "pure-play" companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in recent years. Company Sales in Millions ($) Market Value Equity in Millions ($) Market Value Debt in Millions ($) Equity Beta Tax Rate Share Price ($) Relevant Ltd. 752 3,800 0.0 1.702 23 percent 42 ABJ, Inc. 843 2,150 6.5 2.800 23 percent 24 Opus Software Pvt. Ltd. 211 972 13.0 3.400 23 percent 13 Duarte uses the information from the preliminary prospectus for TagOn's initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists of a $2.4 million five-year non-callable bond issue and 1 million common shares. Other information that Duarte has gathered: Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent, with a market value of $2.156 million Risk-free rate of interest 5.25 percent Estimated equity risk premium 7 percent Tax rate 23 percent The asset betas for Relevant, ABJ, and Opus, respectively, are: 1.70, 2.52, and 2.73. 1.70, 2.79, and 3.37. 1.70, 2.81, and 3.44.
B is correct. Asset betas: βequity/[1 + (1 − t)(D/E)] Relevant = 1.702/[1 + (0.77)(0)] = 1.702 ABJ = 2.8/[1 + (0.77)(0.003)] = 2.7918 Opus = 3.4/1 + [(0.77)(0.013)] = 3.3663
Trumpit Resorts Company currently has 1.2 million common shares of stock outstanding and the stock has a beta of 2.2. It also has $10 million face value of bonds that have five years remaining to maturity and 8 percent coupon with semi-annual payments, and are priced to yield 13.65 percent. If Trumpit issues up to $2.5 million of new bonds, the bonds will be priced at par and have a yield of 13.65 percent; if it issues bonds beyond $2.5 million, the expected yield on the entire issuance will be 16 percent. Trumpit has learned that it can issue new common stock at $10 a share. The current risk-free rate of interest is 3 percent and the expected market return is 10 percent. Trumpit's marginal tax rate is 30 percent. If Trumpit raises $7.5 million of new capital while maintaining the same debt-to-equity ratio, its weighted average cost of capital is closest to: 14.5 percent. 15.5 percent. 16.5 percent.
B is correct. Capital structure: Market value of debt: FV = $10,000,000, PMT = $400,000, N = 10, I/YR = 13.65%. Solving for PV gives the answer $7,999,688. Market value of equity: 1.2 million shares outstanding at $10 = $12,000,000 Market value of debt $7,999,688 40% Market value of equity 12,000,000 60% Total capital $19,999,688 100% To raise $7.5 million of new capital while maintaining the same capital structure, the company would issue $7.5 million × 40% = $3.0 million in bonds, which results in a before-tax rate of 16 percent. rd(1 − t) = 0.16(1 − 0.3) = 0.112 or 11.2% re = 0.03 + 2.2 (0.10 − 0.03) = 0.184 or 18.4% WACC = [0.40(0.112)] + [0.6(0.184)] = 0.0448 + 0.1104 = 0.1552 or 15.52%
A financial analyst at Buckco Ltd. wants to compute the company's weighted average cost of capital (WACC) using the dividend discount model. The analyst has gathered the following data: Before-tax cost of new debt 8 percent Tax rate 40 percent Target debt-to-equity ratio 0.8033 Stock price $30 Next year's dividend $1.50 Estimated growth rate 7 percent Buckco's WACC is closest to: 8 percent. 9 percent. 12 percent.
B is correct. Cost of equity = D1/P0 + g = $1.50 / $30 + 7% = 5% + 7% = 12% D / (D + E) = 0.8033 / 1.8033 = 0.445 WACC = [(0.445) (0.08)(1 − 0.4)] + [(0.555)(0.12)] = 8.8%
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level Sandell is interested in the weighted average cost of capital of Kruspa AB prior to its investing in the China project. This weighted average cost of capital (WACC) is closest to: 7.65 percent. 9.23 percent. 10.17 percent.
B is correct. WACC = [(€900/€3300) .0925 (1 − 0.375)] + [(€2400/€3300)(0.1052)] = 0.0923 or 9.23%
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level Using the capital asset pricing model, Kruspa's cost of equity capital for its typical project is closest to: 7.62 percent. 10.52 percent. 12.40 percent.
B is correct. re = 0.0425 + (1.3)(0.0482) = 0.1052 or 10.52%
Morgan Insurance Ltd. issued a fixed-rate perpetual preferred stock three years ago and placed it privately with institutional investors. The stock was issued at $25 per share with a $1.75 dividend. If the company were to issue preferred stock today, the yield would be 6.5 percent. The stock's current value is: $25.00. $26.92. $37.31.
B is correct. The company can issue preferred stock at 6.5%. Pp = $1.75/0.065 = $26.92
The cost of equity is equal to the: expected market return. rate of return required by stockholders. cost of retained earnings plus dividends.
B is correct. The cost of equity is defined as the rate of return required by stockholders.
Brandon Wiene is a financial analyst covering the beverage industry. He is evaluating the impact of DEF Beverage's new product line of flavored waters. DEF currently has a debt-to-equity ratio of 0.6. The new product line would be financed with $50 million of debt and $100 million of equity. In estimating the valuation impact of this new product line on DEF's value, Wiene has estimated the equity beta and asset beta of comparable companies. In calculating the equity beta for the product line, Wiene is intending to use DEF's existing capital structure when converting the asset beta into a project beta. Which of the following statements is correct? Using DEF's debt-to-equity ratio of 0.6 is appropriate in calculating the new product line's equity beta. Using DEF's debt-to-equity ratio of 0.6 is not appropriate, but rather the debt-to-equity ratio of the new product, 0.5, is appropriate to use in calculating the new product line's equity beta. Wiene should use the new debt-to-equity ratio of DEF that would result from the additional $50 million debt and $100 million equity in calculating the new product line's equity beta.
B is correct. The debt-to-equity ratio of the new product should be used when making the adjustment from the asset beta, derived from the comparables, to the equity beta of the new product.
The Gearing Company has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8 percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7 percent. Gearing intends to maintain its current capital structure as it raises additional capital. In making its capital-budgeting decisions for the average-risk project, the relevant cost of capital is: 4 percent. 7 percent. 8 percent.
B is correct. The weighted average cost of capital, using weights derived from the current capital structure, is the best estimate of the cost of capital for the average-risk project of a company.
An analyst gathered the following information about a company and the market: Current market price per share of common stock $28.00 Most recent dividend per share paid on common stock (D0) $2.00 Expected dividend payout rate 40% Expected return on equity (ROE) 15% Beta for the common stock 1.3 Expected rate of return on the market portfolio 13% Risk-free rate of return 4% Using the Capital Asset Pricing Model (CAPM) approach, the cost of retained earnings for the company is closest to: 13.6%. 15.7%. 16.1%.
B is correct. Using the CAPM approach, 4% + 1.3(9%) = 15.7%.
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level In his report, Sandell would like to discuss the sensitivity of the project's net present value to the estimation of the cost of equity. The China project's net present value calculated using the equity beta without and with the country risk premium are, respectively: €26 million and €24 million. €28 million and €25 million. €30 million and €27 million.
C is correct. Cost of equity without the country risk premium: re = 0.0425 + 3.686 (0.0482) = 0.2202 or 22.02% Cost of equity with the country risk premium: re = 0.0425 + 3.686 (0.0482 + 0.0188) = 0.2895 or 28.95% Weighted average cost of capital without the country risk premium: WACC = [0.80 (0.0925) (1 − 0.375) ] + [0.20 (0.2202)] = 0.04625 + 0.04404 = 0.09038 or 9.03 percent Weighted average cost of capital with the country risk premium: WACC = [0.80 (0.0925) (1 − 0.375) ] + [0.20 (0.2895)] = 0.04625 + 0.0579 = 0.1042 or 10.42 percent NPV without the country risk premium: NPV=€48million(1+0.0903)1+€52million(1+0.0903)2+€54.4million(1+0.0903)3− €100million= €44.03million+43.74million+41.97million− €100million= €29.74million NPV with the country risk premium: NPV=€48million(1+0.1042)1+€52million(1+0.1042)2+€54.4million(1+0.1042)3− €100million= €43.47million+42.65million+40.41million− €100million= €26.53million
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level Sandell is performing a sensitivity analysis of the effect of the new project on the company's cost of capital. If the China project has the same asset risk as Kruspa, the estimated project beta for the China project, if it is financed 80 percent with debt, is closest to: 1.300. 2.635. 3.686.
C is correct. Project beta = 1.053 {1 + [(1 − 0.375)(€80/€20)]} = 1.053 {3.5} = 3.686
Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a US-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable "pure-play" companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the US NASDAQ. The debt ratio of the industry has risen slightly in recent years. Company Sales in Millions ($) Market Value Equity in Millions ($) Market Value Debt in Millions ($) Equity Beta Tax Rate Share Price ($) Relevant Ltd. 752 3,800 0.0 1.702 23 percent 42 ABJ, Inc. 843 2,150 6.5 2.800 23 percent 24 Opus Software Pvt. Ltd. 211 972 13.0 3.400 23 percent 13 Duarte uses the information from the preliminary prospectus for TagOn's initial offering. The company intends to issue 1 million new shares. In his conversation with the investment bankers for the deal, he concludes the offering price will be between $7 and $12. The current capital structure of TagOn consists of a $2.4 million five-year non-callable bond issue and 1 million common shares. Other information that Duarte has gathered: Currently outstanding bonds $2.4 million five-year bonds, coupon of 12.5 percent, with a market value of $2.156 million Risk-free rate of interest 5.25 percent Estimated equity risk premium 7 percent Tax rate 23 percent The average asset beta for the pure players in this industry, Relevant, ABJ, and Opus, weighted by market value of equity is closest to: 1.67. 1.97. 2.27.
C is correct. Weights are determined based on relative market values: Pure-Play Market Value of Equity in Millions Proportion of Total Relevant $3,800 0.5490 ABJ 2,150 0.3106 Opus 972 0.1404 Total $6,922 1.0000 Weighted average beta (0.5490)(1.702) + (0.3106)(2.7918) + (0.1404)(3.3572) = 2.27.
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level As part of the sensitivity analysis of the effect of the new project on the company's cost of capital, Sandell is estimating the cost of equity of the China project considering that the China project requires a country equity premium to capture the risk of the project. The cost of equity for the project in this case is closest to: 10.52 percent. 19.91 percent. 28.95 percent.
C is correct. re = 0.0425 + 3.686(0.0482 + 0.0188) = 0.2895 or 28.95%
Fran McClure of Alba Advisers is estimating the cost of capital of Frontier Corporation as part of her valuation analysis of Frontier. McClure will be using this estimate, along with projected cash flows from Frontier's new projects, to estimate the effect of these new projects on the value of Frontier. McClure has gathered the following information on Frontier Corporation: Current Year ($) Forecasted for Next Year ($) Book value of debt 50 50 Market value of debt 62 63 Book value of shareholders' equity 55 58 Market value of shareholders' equity 210 220 The weights that McClure should apply in estimating Frontier's cost of capital for debt and equity are, respectively: wd = 0.200; we = 0.800. wd = 0.185; we = 0.815. wd = 0.223; we = 0.777.
C is correct. wd = $63/($220 + 63) = 0.223 we = $220/($220 + 63) = 0.777
Dot.Com has determined that it could issue $1,000 face value bonds with an 8 percent coupon paid semi-annually and a five-year maturity at $900 per bond. If Dot.Com's marginal tax rate is 38 percent, its after-tax cost of debt is closest to: 6.2 percent. 6.4 percent. 6.6 percent.
C is correct. FV = $1,000; PMT = $40; N = 10; PV = $900 Solve for i. The six-month yield, i, is 5.3149% YTM = 5.3149% × 2 = 10.62985% rd(1 − t) = 10.62985%(1 − 0.38) = 6.5905%
Using the dividend discount model, what is the cost of equity capital for Zeller Mining if the company will pay a dividend of C$2.30 next year, has a payout ratio of 30 percent, a return on equity (ROE) of 15 percent, and a stock price of C$45? 9.61 percent. 10.50 percent. 15.61 percent.
C is correct. First calculate the growth rate using the sustainable growth calculation, and then calculate the cost of equity using the rearranged dividend discount model: g = (1 - Dividend payout ratio)(Return on equity) = (1 - 0.30)(15%) = 10.5% re = (D1 / P0) + g = ($2.30 / $45) + 10.50% = 15.61%
An analyst gathered the following information about a private company and its publicly traded competitor: Comparable Companies Tax Rate (%) Debt/Equity Equity Beta Private company 30.0 1.00 N.A. Public company 35.0 0.90 1.75 Using the pure-play method, the estimated equity beta for the private company is closest to: 1.029. 1.104. 1.877.
C is correct. Inferring the asset beta for the public company: unlevered beta = 1.75/[1 + (1 − 0.35) (0.90)] = 1.104. Relevering to reflect the target debt ratio of the private firm: levered beta = 1.104 × [1 + (1 − 0.30) (1.00)] = 1.877.
The cost of debt can be determined using the yield-to-maturity and the bond rating approaches. If the bond rating approach is used, the: coupon is the yield. yield is based on the interest coverage ratio. company is rated and the rating can be used to assess the credit default spread of the company's debt.
C is correct. The bond rating approach depends on knowledge of the company's rating and can be compared with yields on bonds in the public market.
An analyst gathered the following information about the capital markets in the United States and in Paragon, a developing country. Selected Market Information (%) Yield on US 10-year Treasury bond 4.5 Yield on Paragon 10-year government bond 10.5 Annualized standard deviation of Paragon stock index 35.0 Annualized standard deviation of Paragon dollar-denominated government bond 25.0 Based on the analyst's data, the estimated country equity premium for Paragon is closest to: 4.29%. 6.00%. 8.40%.
C is correct. The country equity premium can be estimated as the sovereign yield spread times the volatility of the country's stock market relative to its bond market. Paragon's equity premium is (10.5% - 4.5%) × (35%/25%) = 6% × 1.4 = 8.40%.
An analyst gathered the following information about a company and the market: Current market price per share of common stock $28.00 Most recent dividend per share paid on common stock (D0) $2.00 Expected dividend payout rate 40% Expected return on equity (ROE) 15% Beta for the common stock 1.3 Expected rate of return on the market portfolio 13% Risk-free rate of return 4% Using the discounted cash flow (DCF) approach, the cost of retained earnings for the company is closest to: 15.7%. 16.1%. 16.8%.
C is correct. The expected return is the sum of the expected dividend yield plus expected growth. The expected growth is (1 − 0.4)15% = 9%. The expected dividend yield is $2.18/$28 = 7.8%. The sum is 16.8%.
Jurgen Knudsen has been hired to provide industry expertise to Henrik Sandell, CFA, an analyst for a pension plan managing a global large-cap fund internally. Sandell is concerned about one of the fund's larger holdings, auto parts manufacturer Kruspa AB. Kruspa currently operates in 80 countries, with the previous year's global revenues at €5.6 billion. Recently, Kruspa's CFO announced plans for expansion into China. Sandell worries that this expansion will change the company's risk profile and wonders if he should recommend a sale of the position. Sandell provides Knudsen with the basic information. Kruspa's global annual free cash flow to the firm is €500 million and earnings are €400 million. Sandell estimates that cash flow will level off at a 2 percent rate of growth. Sandell also estimates that Kruspa's after-tax free cash flow to the firm on the China project for next three years is, respectively, €48 million, €52 million, and €54.4 million. Kruspa recently announced a dividend of €4.00 per share of stock. For the initial analysis, Sandell requests that Knudsen ignore possible currency fluctuations. He expects the Chinese plant to sell only to customers within China for the first three years. Knudsen is asked to evaluate Kruspa's planned financing of the required €100 million with a €80 public offering of 10-year debt in Sweden and the remainder with an equity offering. Additional information: Equity risk premium, Sweden 4.82 percent Risk-free rate of interest, Sweden 4.25 percent Industry debt-to-equity ratio 0.3 Market value of Kruspa's debt €900 million Market value of Kruspa's equity €2.4 billion Kruspa's equity beta 1.3 Kruspa's before-tax cost of debt 9.25 percent China credit A2 country risk premium 1.88 percent Corporate tax rate 37.5 percent Interest payments each year Level In his estimation of the project's cost of capital, Sandell would like to use the asset beta of Kruspa as a base in his calculations. The estimated asset beta of Kruspa prior to the China project is closest to: 1.053. 1.110. 1.327.
A is correct. Asset beta = Unlevered beta = 1.3/(1 + [(1−0.375)(€900/€2400)] = 1.053
Two years ago, a company issued $20 million in long-term bonds at par value with a coupon rate of 9 percent. The company has decided to issue an additional $20 million in bonds and expects the new issue to be priced at par value with a coupon rate of 7 percent. The company has no other debt outstanding and has a tax rate of 40 percent. To compute the company's weighted average cost of capital, the appropriate after-tax cost of debt is closest to: 4.2%. 4.8%. 5.4%.
A is correct. The relevant cost is the marginal cost of debt. The before-tax marginal cost of debt can be estimated by the yield to maturity on a comparable outstanding. After adjusting for tax, the after-tax cost is 7(1 − 0.4) = 7(0.6) = 4.2%.
