Exam 12: Capital Structure

Estimating the cost of common equity using the discounted cash flow approach may be difficult to evaluate because

Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity.The firm expects to earn $600 in after-tax income during the coming year, and it will retain 40 percent of those earnings.The current market price of the firm's stock is P0 = $28; its last dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent.Allison can issue new common stock at a 15 percent flotation cost.What Will Allison's marginal cost of equity capital (not the WACC) be if it must fund a capital budget requiring $600 in total new capital?

Firms should use their weighted average cost of capital (WACC) when they are funding their capital projects with a variety of sources.However, when the firm plans on using only debt or only equity to fund a particular project, it should use the after-tax cost of the specific source of capital to evaluate that project.

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.What is the maximum amount of new capital that can be raised at the lowest component cost of equity? (In other words, what is the retained earnings break point?)

Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets.Holders of the stock will receive an annual dividend equal to $9.35.The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent.What is Diggin's cost of preferred stock, rps?

The cost of capital is the firm's average cost funds given what the market demands be paid to attract the funds.

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' cost of preferred stock?

The component costs of capital are market-determined variables in as much as they are based on investors' required returns.

A firm going from a lower to a higher tax bracket could increase its use of debt, yet actually wind up with a lower after-tax cost of debt.

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

If a firm can shift its capital structure so as to change its weighted average cost of capital (WACC), which of the following results would be preferred?

The weighted average cost of capital increases if the total funds required call for an amount of equity in excess of what can be obtained as retained earnings.

Tax adjustments to the cost of preferred stock must be made when determining the cost of capital since dividend expenses on preferred stocks are tax deductible.

Even if a firm obtains all of its common equity from retained earnings, its MCC schedule might still increase if very large amounts of new capital are needed.

SW Ink's preferred stock, which pays a $5 dividend each year, currently sells for $62.50.The company's marginal tax rate is 40 percent.What is the cost of preferred stock, rps, that should be included in the computation of the SW Ink's weighted average cost of capital (WACC)?

In general, it is not possible for re, the cost of new equity, to be lower than rs, the cost of retained earnings. However, an exception to this rule occurs when the stock price increases just prior to the firm issuing new equity such that it more than offsets the flotation costs and thus, re becomes less than rs.

Anderson Company has four investment opportunities with the following costs (all costs are paid at t = 0) and estimated internal rates of return (IRR): \ 2,000 16.0\% 3,000 14.5 5,000 11.5 3,000 9.5 The company has a target capital structure which consists of 40 percent common equity, 40 percent debt, and 20 percent preferred stock.The company has $1,000 in retained earnings.The company expects its year-end dividend To be $3.00 per share (i.e., $\hat { \mathrm { D } } _ { 1 }$ = $3.00).The dividend is expected to grow at a constant rate of 5 percent a year.The Company's stock price is currently $42.75.If the company issues new common stock, the company will pay its investment bankers a 10 percent flotation cost.The company can issue corporate bonds with a yield to maturity of 10 percent.The company is in the 35 percent tax bracket.How large can the cost of preferred stock be (including flotation costs) and it still be profitable for the company to invest in all four projects?

A firm's capital structure has no impact on the firm's weighted average cost of capital.

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.How much should an investor be willing to pay for this stock today?