Exam 9: The Cost of Capital

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

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

Table 9.3 Balance Sheet General Talc Mines December 31, 2003 -Promo Pak has compiled the following financial data: (a) Calculate the weighted average cost of capital using book value weights. (b) Calculate the weighted average cost of capital using market value weights.

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

The ________ is the rate of return a firm must earn on its investments in projects in order to maintain the market value of its stock.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. 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 before-tax cost of debt is ________. (See Table 9.2)

The cost of common stock equity is

The cost of preferred stock is typically higher than the cost of long-term debt (bonds) because the cost of long-term debt (interest) is tax deductible.

Table 9.2 A firm has determined its optimal structure which is composed of the following sources and target market value proportions. 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 weighted average cost of capital up to the point when retained earnings are exhausted is ________. (See Table 9.2)

The cost of retained earnings is

The cost of capital is a static concept; it is not affected by economic and firm-specific factors such as business risk and financial risk.

The weighted average cost of capital (WACC) reflects the expected average future cost of funds over the long run.

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

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

Nico Trading Corporation is considering issuing preferred stock. The preferred stock would have a par value of $75 and a preferred dividend of 7.5 percent of par. In order to issue the stock, Nico trading would have to pay flotation costs of 6 percent of par value. Given this information, Nico Trading's cost of preferred stock would be 7.5 percent.

Using the capital asset pricing model, the cost of common stock equity is the return required by investors as compensation for

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.

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. 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 four years. Four 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 Table 9.1)

Table 9.1 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. 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 four years. Four 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 after-tax cost of debt is ________. (See Table 9.1)

In general, floatation costs include two components, underwriting costs and administrative costs.