Exam 9: The Cost of Capital

The Gordon model is based on the premise that the value of a share of stock is equal to the sum of all future dividends it is expected to provide over an infinite time horizon.

A firm may face increases in the weighted average cost of capital either when retained earnings have been exhausted or due to increases in debt, preferred stock, and common equity costs as additional new funds are required.

In computing the weighted average cost of capital, from a strictly theoretical point of view, the preferred weighing scheme is target market value proportions.

In computing the weighted average cost of capital, the historic weights are either book value or market value weights based on actual capital structure proportions.

The target capital structure is the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain.

The Titanic Company has just gone public. Under a firm commitment agreement, Titanic received$14 for each of the 2 million shares sold. The initial offering price was $15 per share, and the stockrose to $16.40 per share in the first few minutes of trading. Titanic paid $500,000 in administrative costs. The total floatation costs for the new issue are

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 firm's cost of retained earnings is (See Figure 9.1)

The preferred capital structure weights to be used in the weighted average cost of capital are

A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Source of capital Target market Proportions Long-term debt 60\% Common stock equity 40 DEBT: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. COMMON STOCK: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The firm's cost of retained earnings is

The net proceeds used in calculation of the cost of long-term debt are funds actually received from the sale after paying for flotation costs and taxes.

A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Source of capital Target market Proportions Long-term debt 60\% Common stock equity 40 DEBT: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. COMMON STOCK: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -Assuming the firm plans to pay out all of its earnings as dividends, the weighted average cost of capital is

The before-tax cost of debt for a firm which has a 40 percent marginal tax rate is 12 percent. Theaftertax cost of debt is

A firm has determined its optimal structure which is composed of the following sources and target market value proportions. Source of capital Target market Proportions Long-term debt 60\% Common stock equity 40 DEBT: The firm can sell a 15-year, $1,000 par value, 8 percent bond for $1,050. A flotation cost of 2 percent of the face value would be required in addition to the premium of $50. COMMON STOCK: A firm's common stock is currently selling for $75 per share. The dividend expected to be paid at the end of the coming year is $5. Its dividend payments have been growing at a constant rate for the last five years. Five years ago, the dividend was $3.10. It is expected that to sell, a new common stock issue must be underpriced $2 per share and the firm must pay $1 per share in flotation costs. Additionally, the firm has a marginal tax rate of 40 percent. -The firm's beforetax cost of debt is

What is the dividend on an 8 percent preferred stock that currently sells for $45 and has a face value of $50 per share?

While the return will increase with the acceptance of more projects, the weighted marginal cost of capital will increase because greater amounts of financing will be required.

If a corporation has an average tax rate of 40 percent, the approximate, annual, aftertax cost of debtfor a 15-year, 12 percent, $1,000 par value bond, selling at $950 is

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost ofissuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The costof the preferred stock is

The__________ is the rate of return required by the market suppliers of capital in order to attract their funds to the firm.

The weighted marginal cost of capital is the firm's weighted average cost of capital associated withits next dollar of total financing.

Circumstances in which the constant growth valuation model-the Gordon model-for estimating the value of a share of stock should be used include