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Exam 9: The Cost of Capital

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Question 21

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Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 30.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted?

A) 0.57%
B) 0.63%
C) 0.70%
D) 0.77%
E) 0.85%

F) C) and D)
G) B) and E)

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Question 22

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The CFO of Lenox Industries hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

A) 1.13%
B) 1.50%
C) 1.88%
D) 2.34%
E) 2.58%

F) C) and D)
G) B) and D)

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Question 23

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If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

(The following information applies to Problems 89, 90, 91, and 92.) Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -What is the best estimate of the after-tax cost of debt?

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductable by the issuing firm.

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

Which of the following statements is CORRECT?

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from retained earnings?

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from retained earnings?