Finance Griswold Ch 13

Why is the cost of debt less than the cost of preferred stock if both securities are prices to yield 10 percent in the market?

Cost of debt is less because it is a tax-deductible expense

Why is the cost of issuing new common stock higher than the cost of retained earnings?

Cost of distributing and issuing new securities

In computing the cost of capital, do we use the historical costs of existing debt and equity or the current cost as determined in the market? Why?

Current cost because it is concerned with future costs not past

*discounted payback (DPB)

A capital budgeting method that generates decision rules and associated metrics that choose projects based on how quickly they return their initial investment plus interest.

payback (PB)

A capital budgeting technique that generates decision rules and associated metrics for choosing projects based on how quickly they return their initial investment.

*internal rate of return (IRR)

A capital budgeting technique that generates decision rules and associated metrics for choosing projects based on the implicit expected geometric average of a project's rate of return.

*profitability index (PI)

A decision rule and associated methodology for converting the NPV statistic into a rate-based metric.

interest-rate cognizant

A decision-making process that includes the cost of capital calculation.

*NPV profile

A graph of a project's NPV as a function of the cost of capital

normal cash flows

A set of cash flows with all outflows occurring at the beginning of the set.

*net present value (NPV)

A technique that generates a decision rule and associated metric for choosing projects based on the total discounted value of their cash flows.

mutually exclusive projects

Groups or pairs of projects where you can accept one but not all.

What are the two sources of equity (ownership) capital for the firm?

Retained earnings (RE) and New common stock

If a company is in the 21% tax bracket, and they take out debt at 10% interest, what is the after-tax cost of debt to the company?

10 (1-.21) = 7.9%

If the company is in the 21% tax bracket and they issue preferred stock at a yield of 10%, what is the after-tax cost of the preferred stock?

10%

modified internal rate of return (MIRR)

A capital budgeting method that converts a project's cash flows using a more consistent reinvestment rate prior to applying the IRR decision rule.

Explain why retained earnings have an associated opportunity cost.

Belong to stockholders and stockholders could be doing something else with the money

Why do we use the OVERALL COST OF CAPITAL for the investment decisions even when only one source of capital will be used? (For example, we may be able to finance the entire project using low-cost debt, so why do we need to use the overall cost of capital in analyzing whether or not to accept the project?)

The use of debt increases overall rise of a firm and makes all firms of financing more expensive

Why is the cost of retained earnings the equivalent of the firm's own required rate of return on common stock?

b/c stockholders can earn a return at least equal to their present investment.