Exam 11: Determining the Cost of Capital

The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT?

As the winner of a contest, you are now CFO for the day for Maguire Inc. and your day's job involves raising capital for expansion. Maguire's common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from reinvested earnings?

Collins Group 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. Assets Current assets \ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets \ 139,000,000 Liabilities and Equity Accounts payable \ 10,000,000 Accruals 9,000,000 Current liabilities \ 19,000,000 Long-term debt (40,000 bonds, \ 1,000 par value) 40,000,000 Total liabilities \ 59,000,000 Common stock ( 10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity \ 139,000,000 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 the data for the Collins Group. What is the best estimate of the firm's WACC?

Which of the following statements is CORRECT?

The CEO of Harding Media Inc. as asked you to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $22.00; and gL = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects?

"Capital" is sometimes defined as funds supplied to a firm by investors.

To estimate the company's WACC, Marshall Inc. recently hired you as a consultant. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,050.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of common stock, and it does not expect to issue any new shares. What is its WACC?

Collins Group 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. Assets Current assets \ 38,000,000 Net plant, property, and equipment 101,000,000 Total assets \ 139,000,000 Liabilities and Equity Accounts payable \ 10,000,000 Accruals 9,000,000 Current liabilities \ 19,000,000 Long-term debt (40,000 bonds, \ 1,000 par value) 40,000,000 Total liabilities \ 59,000,000 Common stock ( 10,000,000 shares) 30,000,000 Retained earnings 50,000,000 Total shareholders' equity 80,000,000 Total liabilities and shareholders' equity \ 139,000,000 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 the data for the Collins Group. Based on the CAPM, what is the firm's cost of common stock?

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

The cost of debt, rd, is normally less than rs, so rd(1 σ T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1-T).

Which of the following statements is CORRECT?

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.

Which of the following statements is CORRECT?

You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and gL = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

You were recently hired by Garrett Design, Inc. to estimate its cost of common equity. You obtained the following data: D1 = $1.75; P0 = $42.50; gL = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings?