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Exam 9: The Cost of Capital

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Question 51

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Which of the following statements is CORRECT?

A) If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of r_s and thus WACC that is too high.
B) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value.This is true even if not all of the firm's stockholders are well diversified.
C) An advantage shared by both the dividend growth model and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
D) The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
E) The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

F) A) and B)
G) B) and D)

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Question 52

True/False

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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.

A) True
B) False

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Question 53

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The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method.However, only the dividend growth method is widely used in practice.

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?

Collins Group The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The bal ance sheet and some other in formation are provided below. $\begin{array}{lr}\text { Assets } \\\text { Current assets } & \$ 38,000,000 \\\text { Net plant, property, and equipment } & 101,000,000 \\\text { Total assets } & \$ 139,000,000\\\\\text { Liabilities and Equity }\\\text { Accounts payable } & \$ 10,000,000 \\\text { Accruals } & 9,000,000 \\\text { Current liabilities } & \$ 19,000,000 \\\text { Long-term debt ( } 40,000 \text { bonds, } \$ 1,000 \text { par value) } & 40,000,000 \\\text { Total liabilities } & \$ 59,000,000 \\\text { Common stock (10,000,000 shares) } & 30,000,000 \\\text { Retained earnings } & 50,000,000 \\\text { Total shareholders' equity } & \$ 0,000,000 \\\text { Total liabilities and shareholders' equity } & \$ 139,000,000\end{array}$ 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 betais 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 retum of $14.50 \%$ during the past 5 years. The firm's tax rate is $25 \%$ . -Refer to the data for the Collins Group.What is the best estimate of the after-tax cost of debt?

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

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 25%.An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).