Exam 9: The Cost of Capital

A firm has an equity beta of 1.3. If the market risk premium is 6% and the long-term Government of Canada bond rate is 6%, the firm's cost of equity is 12%.

A firm has common stock with a market price of $100 per share and an expected dividend of $5.61 per share at the end of the coming year. A new issue of stock is expected to be sold for $98, with $2 per share representing the underpricing necessary in the competitive capital market. Flotationcosts are expected to total $1 per share. The dividends paid on the outstanding stock over the past five years are as follows: Year Dividend 1 \ 4.00 2 4.28 3 4.58 4 4.90 5 5.24 The cost of this new issue of common stock is

The cost of new common stock is normally greater than any other long-term financing cost.

The specific cost of each source of long-term financing is based on_________and_________costs.

The__________ is the level of total financing at which the cost of one of the financing componentsrises.

At any given time, the firm's financing costs and investment returns will be affected by the volume of financing and investment undertaken.

Flotation costs reduce the net proceeds from the sale of a bond whether sold at a premium, at a discount, or at its par value.

The firm's optimal mix of debt and equity is called its

ABC Incorporated's 8% coupon bonds, with six years to maturity, are trading at 112. Theapproximate cost of new debt for the firm is 5.7%.

Use of the Capital Asset Pricing Model (CAPM) in measuring the cost of common stock equity differs from the constant growth valuation model in that it directly considers the firm's risk as reflected by beta.

A firm has determined it can issue preferred stock at $115 per share par value. The stock will pay a$12 annual dividend. The cost of issuing and selling the stock is $3 per share. The cost of thepreferred stock is

When the constant growth valuation model is used to find the cost of common stock equity capital, it can easily be adjusted for flotation costs to find the cost of new common stock; the Capital Asset Pricing Model (CAPM) does not provide a simple adjustment mechanism.

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 aftertax cost of debt is

The wealth-maximizing investment decision for a firm occurs when

The cost of capital reflects the cost of funds over the long run measured at a given point in time, based on the best information available.

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

In computing the cost of retained earnings, the net proceeds represent the amount of money retained net of any underpricing and/or flotation costs.

Holding risk constant, the implementation of projects with a rate of return above the cost of capital will decrease the value of the firm, and vice versa.

Using the Capital Asset Pricing Model (CAPM), the cost of common stock equity is the return required by investors as compensation for the firm's nondiversifiable risk.

The cost of retained earnings to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock.