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Exam 9: The Cost of Capital

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Question 21

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Which of the following statements is CORRECT?

A) The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
B) An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
C) The WACC for a firm that pays dividends and regularly issues new equity will be greater than the WACC for an otherwise identical company that pays lower dividends and that rarely issues new equity.
D) Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value.However, this is not true unless all of the firm's stockholders are well diversified.
E) The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds.The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

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

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Question 22

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Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

A) become less risky over time, and this will maximize its intrinsic value.
B) accept too many low-risk projects and too few high-risk projects.
C) become more risky and also have an increasing WACC.Its intrinsic value will not be maximized.
D) continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital.
E) become riskier over time, but its intrinsic value will be maximized.

F) A) and B)
G) A) and E)

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Question 23

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A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend.If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price.What is the firm's cost of preferred stock?

Trahern Baking Co.common stock sells for $32.50 per share.It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%.New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred.What would be the cost of equity from new common stock?

As the winner of a contest, you are now CFO for the day for Maguire Inc.and your day's job involves raising capital for expansion.Maguire'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 reinvested earnings?

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

When working with the CAPM, which of the following factors can be determined with the most precision?

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

The cost of debt, r_d, is normally less than r_s, so r_d(1 − T) will normally be much less than r_s.Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than r_d(1 − T).

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets.They then provide funds to their different divisions for investment in capital projects.The divisions may vary in risk, and the projects within the divisions may also vary in risk.Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity.You have been provided with the following data: D₀ = $0.80; P₀ = $22.50; and g_L = 8.00% (constant) .Based on the dividend growth model, what is the cost of common from reinvested earnings?

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, r_s, than on the interest rate on long-term debt, r_d, 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.

"Capital" is sometimes defined as funds supplied to a firm by investors.

Taylor Inc.estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%.Which of the following projects (A, B, and C) should the company accept?

Which of the following statements is CORRECT?

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

The CEO of Harding Media Inc.as asked you to help estimate its cost of common equity.You have obtained the following data: D₀ = $0.85; P₀ = $22.00; and g_L = 6.00% (constant) .The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00.Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

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 reinvested earnings, whose cost is the average return on the assets that are acquired.

Careco Company and Audaco Inc are identical in size and capital structure.However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%.Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project.Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc.Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y.Which of the following statements is CORRECT?