Exam 12: Capital Structure

Byron Corporation Byron Corporation's present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Next year's net income is projected to be $21,000, and Byron's payout ratio is 30 percent. The company's earnings and dividends are growing at a constant rate of 5 percent; the last dividend (D0) was $2.00; and the current equilibrium stock price is $21.88. Byron can raise all the debt financing it needs at 14.0 percent. If Byron issues new common stock, a 20 percent flotation cost will be incurred. The firm's marginal tax rate is 40 percent. -Refer to Byron Corporation.Assume that at one point along the marginal cost of capital schedule the component cost of equity is 18.0 percent.What is the weighted average cost of capital at that point?

J. Ross and Sons Inc. J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. -Refer to J.Ross and Sons Inc.What is the firm's cost of newly issued preferred stock?

Which of the following statements is correct?

Rollins Corporation Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' retained earnings break point?

There is a jump, or break, in a firm's MCC schedule each time the firm runs out of a particular source of capital at a particular cost.For example, a firm may use up its 10 percent debt and can then issue more debt only if it offers a higher rate to investors.

Rollins Corporation Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's net income is expected to be $1 million, and its dividend payout ratio is 40 percent. Flotation costs on new common stock total 10 percent, and the firm's marginal tax rate is 40 percent. -Refer to Rollins Corporation.What is Rollins' WACC once it starts using new common stock financing?

Which of the following statements is false?

The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period.

Which of the following steps is not necessary for calculating the marginal cost of capital schedule?

Typically, according to the text, the MCC schedule is either horizontal or rising, which implies that the cost of capital to a firm increases as it raises larger and larger amounts of capital.The rising section of MCC schedule

Capital refers to items on the right-hand side of a firm's balance sheet.

The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases.

J. Ross and Sons Inc. J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. The firm's current after-tax cost of debt is 6 percent, and it can sell as much debt as it wishes at this rate. The firm's preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. Ross expects to retain $15,000 in earnings over the next year. Ross' common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. -Refer to J.Ross and Sons Inc.Where will a break in the WACC curve occur?

The before-tax cost of debt, rd, is the same as the

Since 70 percent of preferred dividends received by a corporation is excluded from taxable income, the component cost of equity for a company which pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rs(1 − T)(0.70)(0.50).

Which of the following statements is most correct?

Jackson Company The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 5 percent of the current market price. -Refer to Jackson Company.What will be Jackson's cost of new common stock if it issues new stock in the marketplace today?

Consider the discussions concerning the cost of common equity.What is the relationship between the cost of retained earnings (internal equity), rs, and the cost of new common equity (external equity), re?

Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, its growth rate is a constant 5 percent, and the company would incur a flotation cost of 15 percent if it sold new common stock.Net income for the coming year is expected to be $500,000 and the firm's payout ratio is 60 percent.The firm's common equity ratio is 30 percent and it has no preferred stock outstanding.The firm can borrow up to $300,000 at an interest rate of 7 percent; any additional debt will have an interest rate of 9 percent.Your company's tax rate is 40 percent.If the firm has a capital budget of $1,000,000, what is the WACC for the last dollar of capital the company raises?

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.