Exam 11: Determining the Cost of Capital

In general,firms should use their weighted average cost of capital (WACC)to evaluate capital budgeting projects because most projects are funded with general corporate funds,which come from a variety of sources.However,if the firm plans to use only debt or only equity to fund a particular project,it should use the after-tax cost of that specific type of capital to evaluate that project.

If investors' aversion to risk rose,causing the slope of the SML to increase,this would have a greater impact on the required rate of return on equity,r_s,than on the interest rate on long-term debt,r_d,for most firms.Other things held constant,this would lead to an increase in the use of debt and a decrease in the use of equity.However,other things would not stay constant if firms used a lot more debt,as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years,then the firm will most likely

The lower the firm's tax rate,the lower will be its after-tax cost of debt and also its WACC,other things held constant.

Avery Corporation's target capital structure is 35% debt,10% preferred,and 55% common equity.The interest rate on new debt is 6.50%,the yield on the preferred is 6.00%,the cost of common from reinvested earnings is 11.25%,and the tax rate is 40%.The firm will not be issuing any new common stock.What is Avery's WACC?

If the expected dividend growth rate is zero,then the cost of external equity capital raised by issuing new common stock (r_e)is equal to the cost of equity capital from retaining earnings (r_s)divided by one minus the percentage flotation cost required to sell the new stock, (1 − F).If the expected growth rate is not zero,then the cost of external equity must be found using a different formula.

Exhibit 11.1 The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Current assets Net plant, property, and equipment Total assets Accounts payable Accruals Current liabilities Long-term debt ( 40,000 bonds, \ 1,000 par value) Total liabilities Common stock ( 10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity \ 38,000,000 101,000,000 \ 10,000,000 9,000,000 \ 19,000,000 30,000,000 50,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -Refer to Exhibit 11.1.Which of the following is the best estimate for the weight of debt for use in calculating the firm's WACC?

Exhibit 11.1 The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Current assets Net plant, property, and equipment Total assets Accounts payable Accruals Current liabilities Long-term debt ( 40,000 bonds, \ 1,000 par value) Total liabilities Common stock ( 10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity \ 38,000,000 101,000,000 \ 10,000,000 9,000,000 \ 19,000,000 30,000,000 50,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -Refer to Exhibit 11.1.Based on the CAPM,what is the firm's cost of common stock?

If expectations for long-term inflation rose,but the slope of the SML remained constant,this would have a greater impact on the required rate of return on equity,r_s,than on the interest rate on long-term debt,r_d,for most firms.Therefore,the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

Exhibit 11.1 The Collins Group, a leading producer of custom automobile accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. Current assets Net plant, property, and equipment Total assets Accounts payable Accruals Current liabilities Long-term debt ( 40,000 bonds, \ 1,000 par value) Total liabilities Common stock ( 10,000,000 shares) Retained earnings Total shareholders' equity Total liabilities and shareholders' equity \ 38,000,000 101,000,000 \ 10,000,000 9,000,000 \ 19,000,000 30,000,000 50,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. -Refer to Exhibit 11.1.What is the best estimate of the firm's WACC?

You have been hired as a consultant by Feludi Inc.'s CFO,who wants you to help her estimate the cost of capital.You have been provided with the following data: r_RF = 4.10%; RP_M = 5.25%; and b = 1.30.Based on the CAPM approach,what is the cost of common from reinvested earnings?

As a consultant to Basso Inc.,you have been provided with the following data: D₁ = $0.67; P₀ = $27.50; and g = 8.00% (constant).What is the cost of common from reinvested earnings based on the DCF approach?