Topic 9: Cost of Capital

The WACC is denoted in dollar terms. True/False

False the WACC is not the cost of capital in dollar terms, but it is instead the cost of capital in rate-of-return terms.

The cost of debt is denoted in percentage terms. True/False

True

The reason that using external equity is more costly than using internal equity is because of flotation costs. True/False

True

Upon bankruptcy, preferred stock holders do not have claim on the assets of the firm. True/False

True

A firm just announced a new preferred stock issue. The preferred dividend, which will be paid in perpetuity, is expected to be $4.10. The return required by shareholders is 10%. What is the cost of preferred equity in percent? (Round to the nearest hundredth: .00)

Answer: 10 Cost of preferred equity: 10%

A firm that is financed with both internal and external equity will have a WACC that is higher when flotation costs are higher. True/False

True

According to a survey by Graham and Harvey (2001), the Capital Asset Pricing Model is the most widely used method for calculating the cost of common equity. True/False

True

Finding the cost of preferred stock requires the use of the perpetuity model. True/False

True

Flotation costs are paid to firms that underwrite the new security issues. True/False

True

Suppose a company has an after-tax cost of debt of 4%, and the cost of common equity of 17%. Also assume the market value of the firm is $10 million, with $4.5 million in debt and $5.5 million in common equity. What is the firm's WACC in percent? (Round to the nearest hundredth: .00)

Answer: 11.15 WACC = (5.5/10)*17% +(4.5/10)*4% = 11.15%

A firm just announced a new preferred stock issue. The preferred dividend, which will be paid in perpetuity, is expected to be $5.85. The price of the preferred stock is expected to be $49 per share. What is the cost of preferred equity in percent? (Round to the nearest hundredth: .00)

Answer: 11.94 Cost of preferred equity: 5.85/49 = 11.94%

A company is planning to issue new equity in order to raise capital. The current share price is $45 and the company is planning to pay a dividend of $2.50 and grow the dividend at a constant rate of 6% per year, indefinitely. If flotation costs are $3 per share, what is the cost of common equity? (Round to the nearest hundredth: .00)

Answer: 11.95 Cost of common equity: 2.50/(45-3) + .06 = 11.95%

Suppose a firm is looking to calculate the cost of common equity using the dividend growth (Gordon) model. The company has just paid a dividend of $4.50 and anticipates growing its dividend at a constant rate of 4% indefinitely. If the current price of the company is valued at $50, what is the cost of common equity in percent (Round to the nearest hundredth: .00)

Answer: 13.36 Cost of Common Equity: Re = [4.50(1.04)]/50 + .04 = 13.36%

Suppose a company is financed entirely with equity. Further suppose that the company is financed with 70% internal equity and 30% external equity. The company currently has a share price of $50. The company recently paid a dividend of $4 and expects to grow the dividend by a constant rate of 5% per year, indefinitely. If flotation costs sum to 6%, what is the WACC of this company in percent? (Round to the nearest hundredth: .00).

Answer: 13.64 Cost of common equity: (4*1.05)/50 + .05 = 13.4% WACC: .70*13.4% + .30*13.4%(1.06) = 9.38% + 4.26% = 13.64%

Suppose a company is financed entirely with equity. Further suppose that the company is financed with 60% internal equity and 40% external equity. The company has a beta of 1.2, expected returns on the market are 13.5%, and the risk free rate is 3.5%. If flotation costs have historically summed to 4.5%, what is the WACC of this company in percent? (Round to the nearest hundredth: .00.)

Answer: 15.78 Cost of common equity: 3.5%+1.2(13.5%-3.5%) = 15.5% WACC: .60*15.5% + .40*15.5%(1.045) = 9.3% + 6.48% = 15.78%

Suppose a company is financed entirely with equity. Further suppose that the company is financed with 75% internal equity and 25% external equity. The company has a beta of 1.1, expected returns on the market are 14.5%, and the risk free rate is 3%. If flotation costs have historically summed to 4%, what is the WACC of this company in percent? (Round to the nearest hundredth: .00.)

Answer: 15.81 Cost of common equity: 3%+1.1(14.5%-3%) = 15.65% WACC: .75*15.65% + .25*15.65%(1.04) = 11.74% + 4.07% = 15.81%

A company has 125,000 $1,000 face value bonds outstanding that are currently priced at 101% of face value. These bonds have 12 years until maturity and pay a 7.5% annual coupon rate, but the coupons are paid semiannually. If the company has a marginal tax rate that is 34%, what is the company's after tax cost of debt in percent? (Round to the nearest hundredth: .00)

Answer: 4.87 After-Tax Cost of Debt: FV = -1000, PMT = -75/2 = -37.50, PV = 1010, N = 12*2=24, CPT I/Y = 3.69*2=7.37% 7.37%*(1-.34) = 4.87%

A company has 75,000 $1,000 face value bonds outstanding that are currently priced at 95% of face value. These bonds have 15 years until maturity and pay an 8% annual coupon rate. If the company has a marginal tax rate that is 40%, what is the company's after tax cost of debtin percent? (Round to the nearest hundredth: .00)

Answer: 5.16 After-Tax Cost of Debt: FV = -1000, PMT = -80, PV = 950, N = 15, CPT I/Y = 8.61%*(1-.40) = 5.16%

Suppose a company is financed with 100% debt. Of the company's debt, 75% is made up of long-term debt. The yield on the company's short-term debt is 6.8% and the yield on the long-term debt is 8.5%. If the marginal tax rate is 34%, what is the weighted average cost of capital in percent? (Round to the nearest hundredth: .00)

Answer: 5.33 WACC: .75*(8.5%)(1-.34) + .25*(6.8%)(1-.34) = 4.21% + 1.12% = 5.33%

Suppose a company is financed with 100% debt. Of the company's debt, 67% is made up of long-term debt. The yield on the company's short-term debt is 8% and the yield on the long-term debt is 10.2%. If the marginal tax rate is 34%, what is the weighted average cost of capital in percent? (Round to the nearest hundredth: .00)

Answer: 6.25 WACC: .67*10.2%(1-.34) + .33*(8%)(1-.34) = 4.51%+1.74% = 6.25%

A company is planning to issue a new $1,000 face value bond that will mature in 10 years. The price of the bond is expected to be $950 and the annual coupon rate is 7.5%. If flotation costs are $12 per bond, what is the before-tax cost of debt in percent? (Round to the nearest hundredth: .00)

Answer: 8.44 Cost of debt: (FV = -1000, PMT = -75, PV = 950-12=938, N = 10, CPT I/Y= 8.44%) 8.44%

Suppose a company has a before-tax cost of debt of 8%, cost of common equity of 15%, cost of preferred equity of 10%, and a marginal tax rate of 34%. Also, assume the market value of the firm is $100 million, with $60 million in debt, $30 million in common equity, and $10 million in preferred equity. What is the firm's WACC in percent? (Round to the nearest hundredth: .00)

Answer: 8.67 WACC = (30/100)*15%+(10/100)*10%+(60/100)*8%*(1-.34) = 8.67%

Suppose a company is valued by the market at $100 million and is financed with both debt and equity. Currently, the company has a market value of equity of $50 million. The company also has a market value of short-term debt of $20 million and a market value of long-term debt of $30 million. The cost of equity is 15%, the cost of short-term debt is 7% and the cost of long-term debt is 8%. If the marginal tax rate is 40%, what is the weighted average cost of capital in percent? (Round to the nearest hundredth: .00)

Answer: 9.78 WACC: (50/100)*15% + (20/100)*7%(1-.40) + (30/100)*(8%)(1-.40) = 7.5%+.84%+1.44% = 9.78%

According to the survey of nearly 400 Chief Financial Officers discussed in the topic, which of the following methods do firms use as methods of calculating the cost of common equity? - Arithmetic Mean - Dividend Discount (Gordon) model - Capital Asset Pricing Model - All of these choices

Answer: All of these choices

Holding all else equal, as the length until maturity increases, the yields on bonds decreases. True/False

Answer: False A longer length to maturity implies greater risk so yields on bonds will actually increase as time to maturity increases.

If marginal tax rates increase, the after-tax cost of debt will increase. True/False

Answer: False An increase in the marginal tax rate reduces the after tax cost of debt.

Flotation costs are costs that are incurred when management miscalculates the cost of capital. True/False

Answer: False Flotation costs are costs associated with the issuance of new equity or debt - often due to underwriting fees.

Flotation costs are higher when management is more inexperienced. True/False

Answer: False Flotation costs are costs associated with the issuance of new equity or debt - often due to underwriting fees.

If a firm has its credit rating downgraded, the cost of debt will increase thus lowering the weighted average cost of capital. True/False

Answer: False If the cost of debt increases it will result in an increase in the WACC.

If a firm expects it growth rate on its dividends to increase, then the firm's cost of capital is likely to decrease. True/False

Answer: False If the dividend growth rate is higher, this will increase the CAPM (or cost of common equity) which will result in an overall higher WACC.

A company can lower its WACC by increasing the percentage of total debt made up from long-term debt. True/False

Answer: False Long term debt generally has a higher yield than short term debt, so increasing the use of long term debt will proportionately increase the WACC.

Using internal equity will increase the WACC more than using external equity. True/False

Answer: False Since the issuance of external equity needs to account for floatation costs, it generally costs more.

The WACC is made up of costs of equity, the costs of debt and new labor costs. True/False

Answer: False The WACC is made up of the cost of debt, cost of preferred stock, and cost of common stock.

The cost of debt is usually considered the return required by shareholders. True/False

Answer: False The cost of debt is the required return by debt holders.

Preferred stock carries voting rights. True/False

Answer: False Unlike common stock, preferred stock does not generally have voting rights.

According to the survey of nearly 400 Chief Financial Officers discussed in the topic, which of the following methods do firms NOT use as methods of calculating the cost of common equity? - Dividend Discount (Gordon) model - Capital Asset Pricing Model - Perpetuity Dividend Model

Answer: Perpetuity Dividend Model

A company's WACC will increase if the company reduces the percentage of its total debt made up from short-term debt. True/False

Answer: True A company's WACC will increase if the company reduces the percentage of its total debt made up from ST debt." The text states that LT debt will have higher yields to maturity than ST bonds (due to risk from the longer term nature of the debt). So if a firm decreases its use of ST debt and instead uses LT debt... it is actually decreasing its use of a lower YTM and increasing its use of a higher YTM resulting in an overall increase to the WACC.

If an already heavily levered firm increases its debt even further, the weighted average cost of capital will likely increase. True/False

Answer: True If a highly levered firm takes on more debt, it becomes a riskier investment and investors will likely require a higher return.

If a firm refinances its debt and extends the length of maturity on all of its bonds, then the cost of capital will increase. True/False

Answer: True Since bonds with longer time to maturity have more risk, this will increase the YTM on the bonds resulting in an overall higher WACC.

According to a survey by Graham and Harvey (2001), the dividend discount (Gordon) model is more widely used to calculate the cost of common equity by firms than the Capital Asset Pricing Model. True/False

False

As flotation costs become more expensive, using internal equity will become more costly than using external equity. True/False

False

If a firm increases the amount of dividends it will pay to shareholders, then the cost of capital will likely decrease. True/False

False

Flotation costs are costs that are incurred when companies issue new securities. True/False

True

If a firm gains greater exposure to systematic risk, then the cost of capital will likely increase. True/False

True

Preferred stock holders have priority in dividends over common stock holders. True/False

True

Short-term bonds generally have lower yields than long-term bonds, holding everything else constant. True/False

True

The after-tax cost of debt is equal to the yield to maturity on a company's bonds multiplied by 1 minus the marginal tax rate. True/False

True

The cost of common equity is defined as the return required by common shareholders. True/False

True

The cost of debt is usually calculated as the interest rate on a company's bonds. True/False

True

When determining the present value of the future cash flows that will come from a capital investment project, you should discount the cash flows with the weighted average cost of capital. True/False

True

When determining whether a particular project will be profitable, the appropriate discount rate is the WACC. True/False

True