Exam 9: The Cost of Capital

A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Source of capital Target market proportions Long-term debt 20\% Preferred stock 10 Common stock equity 70 DEBT: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. PREFERRED STOCK: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. COMMON STOCK: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. -The weighted average cost of capital after all retained earnings are exhausted is

The larger the volume of new financing, the greater the risk and, thus, the higher the financingcosts.

A project's rate of return should be_________than the weighted marginal cost of financing. Thecumulative acceptance of projects _________the weighted marginal cost of capital.

Debt is generally the least expensive source of capital. This is primarily due to

In calculating the cost of common stock equity, the model having the stronger theoretical foundation is

The cost of common stock equity may be measured using either the constant growth valuation model or the capital asset pricing model.

The investment opportunity schedule combined with the weighted marginal cost of capitalindicates

Generally the least expensive source of long-term capital is

A tax adjustment must be made in determining the cost of__________

The constant growth model uses the market price as a reflection of the expected risk-return preference of investors in the marketplace.

In order to recognize the interrelationship between financing and investments, the firm should use__________when evaluating an investment.

The cost of capital reflects the cost of funds

The cost of each type of capital depends on the risk-free cost of that type of funds, the business risk of the firm, and the financial risk of the firm.

Firms underprice new issues of common stock for the following reason(s):

Business risk is the risk to the firm of being unable to cover required financial obligations.

When the net proceeds from the sale of a bond equal its par value, the beforetax cost would just equal the coupon interest rate.

The weighted marginal cost of capital is _________function of total financing in dollars; the internal rate of return on individual projects is _________function of the total capital investment in dollars.

Business risk is the risk to the firm of being unable to cover operating costs.

Generally, the order of cost, from the least expensive to the most expensive, for long-term capital ofa corporation is

As the cumulative amount of money invested in a firm's capital projects increases, its returns on the projects will increase.